The proportion of people living in poverty has increased slightly since the 1970s, according to the official poverty measure. Since the "poverty threshold" used for counting the poor is fixed and unchanging, those numbers suggest a disturbing rise in absolute want. But data on household spending show consumption growth even for those with low incomes. The official poverty rate is seriously flawed, and many analysts are ready to scrap it.

Washington regularly collects vast amounts of data for hundreds upon hundreds of social and economic indicators bearing on poverty. But within that compendium, a single number is widely taken to be more important than the others--the so-called official poverty rate (OPR), which is based on the federal poverty measure established in the 1960s. For four decades, that rate has served as the benchmark for both policy analysis and public discourse regarding the national struggle to reduce the deprivation in our midst. Yet even a casual examination shows that this metric is deeply flawed and increasingly biased toward the overestimation of material poverty.

While the OPR numbers say that the proportion of the American population living in poverty has changed little--indeed, has slightly increased--since the early 1970s, data on household spending show substantial and continuing growth in consumption among those reporting very low incomes. Indeed, it is becoming increasingly clear that the OPR is of no help in figuring where we are today or even where we have come from. Signs are finally on the horizon that analysts on both the left and the right are prepared to scrap the official rate in favor of more realistic ways to track poverty.

A Little History

The poverty rate measure was introduced in 1965 in a landmark study by Mollie Orshansky, an economist and statistician at the Social Security Administration. Drawing on her own research, in which she had experimented with using household income thresholds to identify children living in impoverished conditions, Orshansky proposed a set of income criteria for setting a poverty threshold and determining who lived below it.

Orshansky's threshold was essentially a multiple of the cost of a nutritionally adequate--though humble--diet. For the food-budget anchor, Orshansky used the U.S. Department of Agriculture's "economy food plan," the lower of its two budgets for nonfarm families of modest means. She then applied a multiplier of roughly three--the number varied with family size--to calculate household poverty thresholds. The multiplier itself, incidentally, came from statistics on the ratio of after-tax income to food budgets for all Americans in the 1950s.

Since the early 1970s--the long decades of stagnation in the OPR--the correspondence between the statistic and median family income appears to have broken down altogether.

Using these new poverty thresholds, along with census data on income, Orshansky calculated the total population living below the poverty line for the United States as a whole, as well as for demographic subgroups, for 1963. Although Orshansky's study did not employ the term "poverty rate," talking instead about the "incidence of poverty," the term quickly came to mean the proportion of people or families below the poverty line.

Where's the Beef?

Little has changed since 1965 in the way the federal government measures poverty. The OPR is still calculated annually on the basis of poverty thresholds adjusted for inflation. The rate is and always has been a measure of absolute material poverty--one that intentionally ignores changes in the culture and the economy that influence popular perceptions of what constitutes deprivation.

Estimates of the OPR for the United States are thus available for the past forty-eight years. At first, they gratifyingly tracked the expectations of those who assumed that the rising tide of economic growth would carry all boats. The rate fell by roughly half between the late 1950s and the late 1960s for both families and individuals.

Strikingly, however, the numbers suggest virtually no improvement since then. The lowest OPR yet recorded was for 1973, when the index bottomed out at 11.1 percent. The OPR has since declined for older Americans, for people living alone, and for African Americans. But for most demographic slices--children under eighteen, families, and non-Hispanic whites--the OPR was higher at the start of the new century than it had been in the early 1970s. Low-income Hispanics were somewhat better off in 2006 than in 1973, but the difference is distressingly modest.

To go by the OPR, then, America, through three decades of both Democratic and Republican administrations, has utterly failed to improve the material lot of the more vulnerable elements of society--to raise them above the income line where, according to the author of the federal poverty measure, "everyday living implied choosing between an adequate diet of the most economical sort and some other necessity, because there was not money enough to have both."

Remember the all-boats-rising thesis? Experts on poverty long held that the OPR is largely driven by macroeconomic conditions--employment opportunities and wage rates. In a series of influential publications in the mid-1980s, for example, David Ellwood and Lawrence Summers of Harvard found that "almost all of the variation in the measured poverty rate is tracked by movements in median family income."

But their work only covered 1959–83. Since the early 1970s--the long decades of stagnation in the OPR--the correspondence between the statistic and median family income appears to have broken down altogether. In fact, over the past three-plus decades, data on the median income for American families have provided no clue to the OPR.

Additionally, since 1973, the behavior of the OPR looks increasingly aberrant when compared to other indices widely thought to bear on the risk of poverty in a modern urbanized society. In 1973, nearly 40 percent of adults over the age of twenty-five lacked a high school degree; by 2001, the figure was under 16 percent. Or consider trends in means-tested benefit programs--food stamps, housing subsidies, Medicaid, the Earned Income Tax Credit, and other programs that benefit the poor. Between the 1973 and 2001 fiscal years, spending on those programs more than tripled from $163 billion to $507 billion (in 2004 dollars) and increased by over 130 percent in real, per-capita terms.

The simplest and most plausible explanation for these seeming contradictions is that something is seriously wrong with the way the OPR is calculated. A variety of minor and major technical problems have been noted by specialists over the years--among them, the method for adjusting for inflation and the use of the food budget as the sole benchmark for income sufficiency. One other defect, however, fundamentally flaws the current approach.

The Income-Consumption Mystery

The rate calculation implicitly assumes that consumption by low-income Americans is accurately tracked by their reported incomes. In fact, there is good evidence that, for the lowest fifth of Americans on the income ladder, reported expenditures are almost twice their incomes.

Correcting for changes in household size, real expenditures per person for all Americans were 110 percent higher in 2005 than in 1960–61 for the country as a whole. We do not have precisely comparable figures for poor households, but we do know that the real expenditures of the poorest fifth of households were 112 percent higher in 2005 than the expenditures of the poorest fourth in 1960–61.

Put simply, consumption in low-income households has grown even faster than that of average American households. Moreover, other statistical evidence confirms that lower-income Americans are doing far better than the stagnation in the OPR suggests.

Food and Nutrition. In the early 1960s, inadequate caloric intake was hardly unusual among the officially defined poor. By the end of the century, however, the proportion of the adult population between twenty and seventy-four who were underweight (defined as a body mass index below 18.5) dropped from 4 percent to 1.9 percent.

By the same token, nutritional deprivation among children has been declining. According to the Centers for Disease Control and Prevention, the percentage of low-income children younger than five who were underweight dropped from 8 percent in 1973 to under 5 percent in 2005. (In the same period, the OPR for children rose from 14.4 percent to 17.6 percent.)

Housing and Home Appliances. In 1970, about 14 percent of poverty-level households were officially deemed "overcrowded," with more people than rooms to live in. By 2001, just 6 percent of poor households were overcrowded--a proportion lower than for nonpoor households as recently as 1970. Moreover, between 1980 and 2001, heated floor space per person in the homes of the officially poor increased by 27 percent. And in 2001, just 2.5 percent of poverty-level households lacked plumbing facilities--a lower share than for nonpoor households in 1970.

Trends in furnishings and appurtenances tell the same story: poor households' possession of modern conveniences has been growing rapidly. For many of these items--telephones, television sets, central air conditioning, and microwave ovens--prevalence in poverty-level households in 2001 exceeded that of median-income households in 1980.

Personal Transportation. In 1973, almost three-fifths of the households in the lowest income quintile lacked a car. In 2003, by contrast, over three-fifths of poverty-level households owned one or more cars. In that same year, moreover, 14 percent of households below the poverty line owned two or more cars, and 7 percent had two or more trucks.

Health Care. Between 1970 and 2004, the infant mortality rate fell by a remarkable two-thirds. And it continued its almost uninterrupted decline after 1973, even as the OPR for children began to rise. The disconnect is particularly striking for white infants. Between 1974 and 2004, their mortality rate fell by three-fifths, from 14.8 deaths per thousand to 5.7 deaths per thousand. Yet the OPR for white children rose from 11.2 percent to 14.3 percent.

The gains in access to medical care for infants extend to older children. The proportion of children who did not report a visit to a physician was significantly lower for the poor population in 2004 (12 percent) than it had been for the nonpoor population twenty-two years earlier (17.6 percent).

The more striking anomaly in the OPR that cries out for explanation is that the gap between reported income and personal spending has widened sharply. Between 1960–61 and 2005, the ratio of income to expenditures for all households remained fairly stable, with expenditures exceeding income by a significant amount. The subgroup of poorer households also seemingly overspent. But in contrast to households in general, the margin by which the spending of the poor exceeded reported income has moved steadily upward. In the early 1960s, the ratio was 1.12 for the lowest income quartile. By 1972–73, that ratio had reached 1.4 for the lowest income quintile. (Note again the lack of data on precisely comparable groups.) By 2005, the ratio for the bottom fifth had reached 1.98.

What accounts for the gap? One possible hypothesis is that low-income Americans are overspending at an increasing rate--that is, going ever deeper into debt. By this reasoning, the widening gap represents an unsustainable binge that must eventually come to an end, with doleful consequences for future living standards of the disadvantaged.

The overspending hypothesis, on its face, seems plausible. Luckily, it is confuted by evidence from U.S. Census Bureau and Federal Reserve surveys showing that the average net worth of households in the bottom fifth has actually grown in the last decade. Additionally, the gains in wealth have been broadly shared, with the portion of bottom fifth households reporting no assets whatever falling from 21 percent in 1989 to just 8 percent in 2004.

If the poor are not overspending, is it possible they are underreporting income? There is little doubt. For one thing, the OPR measure of income ignores tens of billions in tax rebates delivered by the Earned Income Tax Credit. By the same token, the poor surely supplement their incomes off the books. But to use the underreporting phenomenon to explain why the gap between spending and income has widened so much, one would also need to explain why underreporting was increasing rapidly. Hence, the explanation for the widening gap more likely lies elsewhere.

Might the growing disparity be explained by another big change in modern America--namely, the rise of illegal immigration? The argument would go like this: there has been a surge of undocumented immigration over the past generation, and illegal immigrants are understandably inclined to underreport their incomes. Yet they have no similar incentives to underreport their consumption in interview-based surveys. Thus, all other things equal, as the undocumented become an ever greater proportion of the lower-income population, the gap between spending and reported income should grow. (Immigrants, furthermore, tend to be savers--think remittance flows--a fact that could also help account for the reported increases in wealth among the poor in recent decades.)

The argument is plausible, but the actual magnitude of the effect is likely to be small. Undocumented immigrants are believed to comprise less than 3 percent of all U.S. residents. Moreover, they are probably undersampled by the survey techniques used by the Census Bureau to estimate the poverty rate.

But even if all illegal immigrants were fully represented in our income and expenditure surveys, if there had been no illegal immigrants in the country in the early 1970s, if all illegal immigrants now fall in the lowest quintile of the U.S. income distribution, and if this entire group reported no income at all, the illegal immigration effect could account for less than half of the rise in the ratio of spending to income that was actually reported by the bottom fifth of American households between 1972 and 2005. In reality, the impact is probably much smaller. If we want to understand the uncanny continuing divergence between reported spending levels and reported income levels for the lowest fifth of American households, then we are going to have to look into the economic circumstances of legal American residents--the overwhelming majority of whom are native-born.

To see where we are heading, note that poverty status is not a fixed, long-term condition for the overwhelming majority of Americans who are ever designated as poor. Quite the contrary: long-term poverty appears to be the lot of only a tiny minority counted as poor in any particular year by the OPR. For example, the Census Bureau found that from 1996 to 1999, fully 34 percent of all households spent two months or more below the poverty line--but only 2 percent stayed below the line in all forty-eight of those months. Both economic theory and common sense suggest that the temporarily poor would try to maintain their living standards in lean times by spending more than they earn.

But this alone would not explain why the spending-income gap increased so much in recent decades. What is needed is a reason to believe that household incomes are more variable than they used to be, sharply increasing the portion of the materially disadvantaged that are only temporarily poor. Here, the accumulating evidence is intriguing. For example, Jacob Hacker of Yale University found that, for households headed by people of working age, the odds of seeing income fall by half or more in the coming year rose from 7 percent in 1970 to 16 percent in 2002.

This unintuitive explanation for the growing income-consumption gap meshes neatly with another surprising bit of survey data. According to the Federal Reserve, differences in net worth for the bottom quintile and the next highest quintile of American families narrowed between 1989 and 2004--hardly what one would expect in light of evidence of growing income inequality since the 1960s. If year-to-year income volatility were on the rise, however, we would expect an increasing share of families permanently lodged in the second quintile to register temporarily in the bottom quintile in any given year--and conversely, we would also expect a rising share of lowest-quintile families to bounce up to the second quintile in any given year. Rising income volatility, in short, could be a key to explaining the seemingly paradoxical behavior of lower-income households with respect to both spending and the accumulation of wealth.

This is, arguably, both good news and bad. On the one hand, it suggests that lower-income Americans are not spending themselves into oblivion. On the other, it implies that income volatility is a large and growing concern for ever more Americans at the short end of the income stick.

What It All Means

We would surely discard a statistical measure that showed life expectancy was falling during a time of ever-increasing longevity, or one that suggested our national finances were balanced in a period of rising budget deficits. Central as the OPR has become to antipoverty policies--or, more precisely, especially because of its central role in such policies--it should likewise be discarded in favor of a more accurate way (or ways) of describing trends in material deprivation.

Do not misinterpret this dismissal of the OPR. Nothing about the analysis here leads me to conclude that poverty is a thing of the past--or even that the general plight of the poor in America is markedly better today than in 1965 when Lyndon Johnson's "War on Poverty" was ramping up. To the contrary, I think that in many tragic respects, the misery and degradation suffered by America's most disadvantaged may well be more acute today than it was forty years ago.

For example, no matter how you measure it, family structure is far more frayed than it was in 1965. While the consequences of family breakdown are seldom auspicious, they tend to be most severe for the poor. By the same token, despite the past decade and a half of decline in major urban areas, crime rates in America remain far higher today than in 1965. And it is no secret that the greatest burden of crime falls directly on the very poorest. The corollary of that crime explosion--today's historically unprecedented levels of prison incarceration for the country's young men--not only reflects on misery in modern America, but contributes to it.

Nor does this study suggest that America's long war on poverty has been a failure. It does not even attempt an overall assessment of the material impact of those policies. At the risk of beating a dead horse, the only issue here is the reliability of the OPR as a measure of poverty. And, whereas the rate shows no progress in reducing poverty over the past three and a half decades, practically every other available statistical indicator points to major improvements in material living standards.

Accommodating such findings will require a fairly major recasting of the conventional narrative about long-term progress against poverty. Yet rethinking what has happened is hardly likely to end disputes over the value of the welfare reform plan of the 1990s or of the efficiency of the government's antipoverty programs. Our contentious, ongoing national debate about the adequacy and efficacy of the social safety net is at its core a dispute over first principles and underlying premises--not the simple facts of how many people go hungry or lack access to a telephone.

New Directions

This study points to some promising avenues for inquiry in the years ahead. Consumption is, without doubt, a more faithful measure of material deprivation than income. Further, the complex (and, for our purposes, crucial) interplay between consumption and income can be much better captured by surveys that track specific households or individuals over time than by "snapshot" measures at a single date. Yet the government's capacity to follow the long-term dynamics of household income and consumption in America is woefully limited--a curious oversight for an information-rich society.

Equally curious is the fact that the first efforts to create an alternative poverty metric are not coming from federal antipoverty agencies, but from New York City, whose mayor, Michael R. Bloomberg, decided that the OPR was all but useless in determining how to spend the city's limited antipoverty resources. So New York City created a new poverty measure. It does not tackle the inherently difficult problem of accounting for year-to-year variability in individual household resources, but it is plainly a step up because it focuses on consumption rather than income.

The first results, released in mid-July, are provocative. The new measure implies that 23 percent of New York's population is poor, as opposed to the OPR's 19 percent. But a much smaller proportion of the recorded poor is shown to be in extreme poverty because the new measure takes into account food stamps and housing subsidies. Conversely, the number of elderly poor is much higher (32 percent) than previously recognized, apparently because of increases in the cost of medical services not covered by government insurance. For now, the New York City metric offers only a snapshot of poverty--a picture of a single point in time--but it should be possible to use this framework to estimate long-term poverty trends.

On the same day New York released its first estimates, the House Ways and Means Subcommittee on Income Security and Family Support held hearings to explore the idea of modernizing the federal measurement of poverty. The subcommittee's chairman, Jim McDermott (D-Wash.), has submitted a bill calling for a new consumption-based metric for poverty derived from decade-old recommendations from the National Academy of Sciences. As with the New York City approach, it does not account for the role of year-to-year income variability in poverty. But it is a start: the process of rethinking the federal government's obsolete official poverty measure has begun.

Nicholas Eberstadt is the Henry Wendt Scholar in Political Economy at AEI.

Thanks BBG for a great post. I agree with their analysis and learned some details I didn't know. I've complained here and elsewhere about the taxpayer-billed farce of the Census Bureau mis-measuring poverty. This study shows that the poor are spending double what we measure for their income which means we are NOT measuring their income, just paying for the studies and basing policies and politics on false information.

My beef is that the Census Bureau does not count non-cash subsidies as income. They don't count the food stamp debit card, the free clothing, free health care and they don't count Section 8 voucher paid housing. We pay it by the trillion. They receive it. And none of it counts. Then the 'experts' just keep telling us the disparity keeps getting worse, we aren't doing enough and they point to 'unimpeachable' sources like the Census Bureau.

FWIW I don't think the non-counting of non-cash subsidies explains the 100% error the study found in comparing income with consumption. I think it is an additional defect making the total error perhaps 200% or more. All about something I think is none of our business, how much money other people make.

With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

Chad CroweThose who want to understand the mechanism might ponder Irving Fisher's comment in 1933: When it comes to booms gone bust, "over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

But the growth of excess reserves also reflects bank disinterest in lending the money. This suggests the banks only want to finance existing positions, such as where they have already made credit-line commitments.

Monetarist Bernanke and others blame Japan's postbubble deflationary downturn on policy errors by the Bank of Japan. But he and others are about to find out that monetary gymnastics are not as effective as they would like to think. So too will the Keynesians who view an aggressive fiscal policy as the best way to counter a deflationary slump. While public-works spending can blunt the downside and provide jobs, it remains the case that FDR's New Deal did not end the Great Depression.

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

Meanwhile, the most recent Fed survey of loan officers provides hard evidence of the intensifying credit crunch in America. A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and midsize firms over the past three months, the highest since the data series began in 1990. A net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months.

Consumers are also more reluctant to borrow. A net 48% of respondents indicated that they had experienced weaker demand for consumer loans of all types over the past quarter, up from 30% in the July survey. This hints at the Japanese outcome of "pushing on a string" -- i.e., the banks can make credit available but cannot force people to borrow.

The Fed Is Out of Ammunition – Christopher WoodWhat a Single Nuclear Warhead Could Do – Brian T. KennedyChange Our Public Schools Need – Terry M. MoeBush Does the Right Thing for Darfur – Kenneth RothWhat happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke's speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s" (Solstice Publishing, 2005).

Nov. 24 (Bloomberg) -- A professor at the diplomatic academy of Russia’s Ministry of Foreign Affairs said the U.S. will break into six parts because of the nation’s financial crisis.

“The dollar isn’t secured by anything,” Igor Panarin said in an interview transcribed by Russian newspaper Izvestia today. “The country’s foreign debt has grown like an avalanche; this is a pyramid, which has to collapse.”

Panarin said in the interview that the financial crisis will worsen, unemployment will rise and people will lose their savings -- factors that will cause the country’s breakup.

“Dissatisfaction is growing, and it is only being held back at the moment by the elections, and the hope” that President- elect Barack Obama “can work miracles,” he said. “But when spring comes, it will be clear that there are no miracles.”

The U.S. will fracture into six parts: the Pacific coast; the South; Texas; the Atlantic coast, central states and the northern states.

“Now we will see a change to the regulatory system on a global financial scale: America will cease to be the world’s regulator,” to be replaced by China and Russia, he said.

TOKYO - Japanese economists, increasingly concerned that the United States might seek to pay its enormous and growing debt obligations in a weakened US dollar, are looking to the possibility of US Treasuries being issued in yen.

The US government needs to borrow at least US$1 trillion in the coming year, excluding the US Treasury's $700 billion plan to bail out the financial and other industries, said Kazuo Mizuno, chief economist in Tokyo at Mitsubishi UFJ Securities Co, a unit of Japan's largest publicly traded lender by assets. That amount is likely to grow as the US government continues to rescue failed parts of the economy and has to raise more debt - that is, issue government bonds, or Treasuries - to fund such rescues.

Since 2004, when the amount of the government bond issuance reached an annual average of $400 billion, 94% of new buyers of US government bonds have been foreigners, Mizuno told Asia Times Online.

One measure of the increased concern at the ability of the United States to finance its enormous deficits in the future is the rising cost of credit default swaps bought as protection of Treasury debt. These traded near a record high on Tuesday, with benchmark 10-year contracts on Treasuries increased to 42 basis points, or 0.42 percentage points, from around 20 in early September. The contracts have also risen from below two basis points at the start of the credit crisis in July 2007.

While it remains unlikely that the US government will default on its debt, a weaker dollar would ease the burden of payment on existing debt.

In the past few months, the US dollar has strengthened against other major currencies, with the notable exception of the yen, even as the country has been at the epicenter of the deepening financial crisis. That dollar strength is not expected to last.

"There is no wonder the dollar will weaken," said Eisuke Sakakibara, Japan's former top currency official and now a professor at Waseda University. "The dollar now looks strong for a technical reason. The money the US financial firms had invested in the world is being repatriated into the homeland, causing dollar-buying. But once this conversion into the dollars is done, the currency will head south," Sakakibara said at a forum in Tokyo on Sunday.

Faced with the unprecedented growth of the US budget deficit and the prospect of an increasingly weaker dollar compared with the yen reducing the value of Treasury debt held by Japan, economists in Tokyo are calling for the administration of president-elect Barack Obama to issue US Treasuries denominated in yen and other currencies. The issuance of foreign currency-denominated US Treasures would reduce the perceived risk of holding the debt.

The idea of issuing foreign currency-denominated US Treasures is not new. The Jimmy Carter administration, buffeted by the two oil crises of the 1970s, sold "Carter bonds", denominated in German marks and Swiss francs, in 1978 to attract foreign investors into Treasuries.

"The US will be forced to issue foreign currency-denominated US Treasures in its hour of need," said Mizuno. "The US cannot finance its deficit by itself. The US financial system cannot survive without foreign investors. We will see 'Obama Bonds' in the future."

With the US owing increasing amounts to foreign nations, the confidence in US Treasuries continues to be shaken, said Masaaki Kanno, chief economist at JPMorgan Securities Japan Co in Tokyo, said. "This will push up long-term yields, and the dollar will be sold," said Kanno, speaking at the forum in Tokyo on Sunday.

So far, the Japanese yen has been the biggest winner out of the current financial turmoil as investors increasingly unwind the so-called yen carry trade, in which yen borrowed at low interest is changed into other currencies and invested for higher yields than the interest charged on the yen loan.

The yen has advanced 15% versus the dollar this year, 33% against the euro and 53% against the pound sterling. The yen may rise to 85 per dollar this year, predicted Masaki Fukui, senior market economist in Tokyo at Mizuho Corporate Bank Ltd, a unit of Japan's second-largest financial group by market value. The Japanese currency at present is trading at about 96.28 to the US dollar.

"Japan’s financial authorities may intervene in the foreign exchange markets only when the yen breaks 90 per dollar," Sakakibara said.

As the yen strengthens, the effective value of debt held in dollars will decline, a fate that yen-denominated Treasuries would escape.

"Yen-denominated US Treasuries would reduce currency risks for Japanese and Chinese buyers of US Treasuries," said Fukui. "If concerns over US Treasuries continue to grow, no one will want to buy them. Yen-denominated US Treasuries would make it easy for foreign investors to buy them."

Looking ahead to 2009, foreign buyers such as Japan, China and other emerging market central banks are likely to reduce their holdings of US Treasuries rather than increase them, as their own countries face massive funding needs to buoy their economies at home and as America will continue to face financial instability and deteriorating economic fundamentals.

Japan holds the world's second-largest foreign reserves, totaling about $1 trillion, following China, which has about $2 trillion in forex reserves, including some $600 billion worth of US Treasuries. Japan plans to provide up to $100 billion to the International Monetary Fund, which would reduce the nation’s holding of short-term US Treasury bills.

China on November 9 announced its sweeping economic stimulus package valued at about 4 trillion yuan ($586 billion), to be spent over the next two years. Market players are speculating China, to secure financial resources, would reduce its holding of US Treasury securities rather than increase them.

Kosuke Takahashi is a freelance correspondent based in Tokyo. He can be contacted at letters@kosuke.net.

Concerted government policy helped trigger the financial meltdown—and will almost certainly extend it.

Michael Flynn | January 2009 Print Edition

It was not an absence of federal intervention that produced the Great Financial Panic of 2008. Contrary to the assertions of those clamoring for new regulations (see "Is Deregulation to Blame?," page 36), the liquidity shortage and credit freeze that triggered Washington's biggest intrusion into the economy since Richard Nixon's wage and price controls were caused by bad government policy and worse crisis management.

As the housing bubble inflated from 1997 to 2006, banks, fueled by the Federal Reserve, prodded by activists, and egged on by Wall Street, created ever more exotic mortgage loans that pushed up housing prices and extended mortgage debt to families vulnerable to economic downturns. Several layers of financial products were tied to these mortgages. As some of the derivative instruments and underlying mortgages collapsed, collateral damage raced through the entire system.

In 2008 the Bush administration took a series of frantic steps to stop the bleeding. It backed a hostile takeover of the investment bank Bear Stearns. It took over home lending behemoths Fannie Mae and Freddie Mac, an act that put $5 trillion worth of mortgages—more than $1 trillion of which are subprime—on the federal government's books, not to mention the $200 billion it had to commit to guarantee Fannie and Freddie's debts. It made hundreds of billions of dollars available to banks through the Fed's "discount window," its mechanism to make short-term loans to certain institutions, put up $85 billion to take over the insurance giant AIG, and offered another $250 billion to individual banks to rebuild their balance sheets.

In October the administration convinced Congress to authorize the Treasury Department to spend upward of $700 billion buying up toxic mortgage-backed securities, most of which contain sizeable numbers of subprime mortgages. Each step not only failed to calm the market but seemed to increase the sense of impending doom (also fanned by sky-is-falling pronouncements from President Bush on down). After a month of U.S. government action, the mortgage crisis had grown into a global financial panic, the repercussions of which we'll be living with for decades.

The Roots of the Crisis

Throughout the 1990s and the early years of this century, both major political parties became intoxicated with the idea of promoting "affordable" housing. By the time the crisis blew up, Congress was mandating that roughly 50 percent of the mortgages issued by Fannie and Freddie go to households making below their area's median income.

Many conservative commentators have blamed the housing mess on the 1977 Community Reinvestment Act (CRA), which essentially required banks to increase lending in low-income areas. While the CRA was a bad law, its role in recent events has been overblown. After all, it was on the books for decades before the bubble began. The law's worst legacy is the permanent network of "affordable housing" advocates that sprang up after it passed. These groups, which were intended to facilitate lending in poor areas, continually called for increased activity by banks and additional government support for affordable housing initiatives. The CRA also helped create a climate in which lending to low-income households was a key metric and condition regulators used in approving bank mergers.

Other, more recent developments played a bigger role in the financial crisis. In 1993 the Federal Reserve Bank of Boston published "Closing the Gap: A Guide to Equal Opportunity Lending." The report recommended a series of measures to better serve low-income and minority households. Most of the recommendations were routine and mundane: better staff training, improved outreach and communication, and the like. But the report also urged banks to loosen their income thresholds for receiving a mortgage. In the years after the report was published, activists and officials—especially in the Department of Housing and Urban Development, under both Bill Clinton and George W. Bush—used its findings to pressure banks to increase their lending to low-income households. By the turn of the century, other changes in federal policy made those demands more achievable.

You can't lend money if you don't have it. And beginning in 2001, the Federal Reserve made sure lots of people had it. In January 2001, when President Bush took office, the federal funds rate, the key benchmark for all interest rates in this country, was 6.5 percent. Then, in response to the meltdown in the technology sector, the Fed began cutting the rate. By August 2001, it was at 3.75 percent. And after the terrorist attacks of September 11, the Fed opened the spigot. By the summer of 2002, the federal funds rate was 1 percent.

The central bank's efforts went so far that, at one point in 2003, we had interest rates below the rate of inflation, or effectively negative. Institutional investors, looking at low yields on Treasury securities, needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on Treasury notes.

Investment houses would bundle individual mortgages from several banks together into bond-like products that they would sell to individual investors. Mortgages historically have been seen as among the safest investments, and the era of rising house values transformed "safe" into "guaranteed returns."

For the first half of this decade, trading in mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. At the same time, investment houses were looking to replace the healthy fees earned during the dot-com bubble. Mortgage-backed securities had fat margins, so everyone jumped into the game.

The additional capital to underwrite mortgages was a good thing—up to a point. Homeownership expanded throughout most of Bush's presidency. During the last few decades, the American homeownership rate has been around 60 percent of adult households. At the height of the bubble, it reached almost 70 percent. It is clear now that many people who got mortgages at the high-water mark should not have. But Wall Street needed to feed the stream of mortgage-backed securities.

Fannie and Freddie

It's hard to overstate the role Fannie Mae and Freddie Mac played in creating this crisis. Chartered by Congress, Fannie in 1938 and Freddie in 1970, the two government-sponsored enterprises provided much of the liquidity for the nation's housing market. Because investors believed—correctly, it turns out—that Fannie Mae and Freddie Mac were backed by an implicit guarantee from the federal government, the companies were able to raise money more cheaply than their competitors. They were also exempt from federal, state, and local taxes.

The chief mission of Fannie Mae and Freddie Mac was to buy up mortgages issued by banks, freeing up bank money for additional mortgages. Fannie and Freddie would package these mortgages into mortgage-backed securities and sell those on the secondary mortgage market, providing cash to continue the cycle. Even when selling these securities, they often retained the full risk for any default, pocketing a portion of the interest payments in return.

Fannie and Freddie would also keep a portion of these mortgages in their own investment portfolios, providing a constant influx of interest payments. Starting in the 1990s, they increasingly created and traded in complex derivatives, financial instruments designed to insulate them, through hedging, from mortgage loan defaults and interest rate increases. From the mid-'90s through the early 2000s, Fannie Mae and Freddie Mac were the darlings of Wall Street, with steady earnings growth and solid credit ratings. Fannie's share priced peaked in 2001 almost 400 percent above its 1995 level; Freddie peaked in 2004, almost 500 percent higher than in 1995. This growth would not last.

In June 2003, Freddie Mac surprised Washington and Wall Street with a management shakeup. The top executives were sent packing, and a new auditor, PricewaterhouseCoopers, identified several accounting irregularities on the company's books, especially related to its portfolio of derivatives. The company would have to restate earnings for the previous several years.

Just days before, the agency responsible for regulating Freddie, the Office of Federal Housing Enterprise Oversight, had reported to Congress that the company's management "effectively conveys an appropriate message of integrity and ethical values." Just how wrong this assessment was would soon become abundantly clear.

As the extent of the accounting irregularities emerged, federal regulators descended on the company and quickly determined that the accounting troubles extended to Fannie Mae as well. With concerns about the companies growing, the Bush administration unveiled proposals to rein them in. Then-Treasury Secretary John Snow proposed putting Fannie and Freddie under his department's oversight and subjecting them to the kind of controls over risk and capital reserves that apply to commercial banks. (Fannie's debt-to-capital ratio was 30 to 1, whereas conventional banks have debt-to-capital ratios of around 11 to 1.)

But Fannie and Freddie by this point were political powerhouses. When the accounting scandal first emerged, Fannie's chairman was Franklin Raines, former director of the Office of Management and Budget under President Bill Clinton. Its vice chairman was Jamie Gorelick, a former Justice Department official who had served on the 9/11 commission. The two companies provided tens of millions of dollars in annual campaign contributions and spent more than $10 million a year combined on outside lobbyists.

Fannie and Freddie rallied their friends on Capitol Hill, who immediately pushed back against the Bush proposals. Rep. Barney Frank (D-Mass.), the ranking Democrat on the House Financial Services Committee, said, "These two entities-Fannie Mae and Freddie Mac-are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." The reform effort fizzled.

In 2006 the Office of Federal Housing Enterprise Oversight issued the blistering results of its investigation. The irregularities, investigators concluded, amounted to "extensive financial fraud." The purpose of the deception was clear: to "smooth" earnings from year to year in order to maintain increasing returns and maximize executive bonuses. Raines, for example, earned more than $50 million in bonuses tied to earnings growth during his six-year tenure.

Interestingly, the report noted two questionable transactions Fannie conducted with the investment bank Goldman Sachs in 2001 and 2002 that pushed more than $100 million of existing profits into the future, creating a kind of cushion for future earnings. The chairman of Goldman Sachs when the dodgy transactions took place was the man behind the 2008 bailout: Treasury Secretary Henry Paulson.

In the end, Fannie and Freddie had to restate more than $15 billion in earnings. The Office of Federal Housing Enterprise Oversight and the Securities and Exchange Commission fined Fannie $400 million and Freddie $125 million. There was a new push for tighter oversight on the Hill, but this too withered as Fannie and Freddie rallied support through increased lending to low-income borrowers.

Then Fannie and Freddie went on a subprime bender. The companies made it clear they wanted to buy up all the subprime mortgages—and Alt-A mortgages, whose risk is somewhere between prime and subprime—that they could find. They eventually acquired around $1 trillion of the paper. The market responded. In 2003 less than 8 percent of all mortgages were subprime. By 2006 the number was more than 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever-increasing amounts of subprime mortgages into mortgage-backed securities, they could add slightly higher levels of risk and, as a result, boost the returns and earn bigger fees. The ratings agencies, thinking they were simply dealing with traditionally appreciating mortgages, didn't look under the hood.

But after several years of a housing boom, the pool of households that could responsibly use the more exotic financing products had dried up. Essentially, there were no more people who qualified for even a subprime mortgage.

Banks realized they could make ever more exotic loan products (such as interest-only loans), get the affordable housing activists off their backs, and immediately diffuse their risks by folding the mortgages into mortgage-backed securities. After all, Fannie and Freddie would buy anything.

Everything worked as long as housing prices continued to rise. Suddenly, though, there weren't enough buyers. (See "Houses of Pain," page 40.) At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable-rate mortgages moved higher; the Fed was finally constricting the money flow, with the federal funds rate peaking at 5.25 percent in July 2006. Mortgages that were initially interestonly were close to resetting, with monthly payments jumping to include principal. A significant number of these mortgages moved into default and foreclosure, which further dampened housing prices.

The overall foreclosure numbers were small; someone simply looking at housing statistics could be forgiven for wondering what all the fuss was about. Nationally, throughout 2007 and 2008, the number of mortgages moving into foreclosure was only about 1 percent to 2 percent, suggesting that 98 percent to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the mortgage-backed securities owned by most financial institutions.

The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as different firms bought and sold them, they were sliced and diced in varying ways. A mortgage-backed security owned by one company could be very different when it was sold to another.

No one fully understood how exposed the mortgage-backed securities were to the rising foreclosures. Because of this uncertainty, it was hard to place a value on them, and the market for the instruments dried up. Accounting regulations required firms to value their assets using the "mark-to-market" rule, i.e., based on the price they could fetch that very day. Because no one was trading mortgage-backed securities anymore, most had to be "marked" at something close to zero.

This threw off banks' capital-to-loan ratios. The law requires banks to hold assets equal to a certain percentage of the loans they give out. Lots of financial institutions had mortgage-backed securities on their books. With the value of these securities moving to zero (at least in accounting terms), banks didn't have enough capital on hand for the loans that were outstanding. So banks rushed to raise money, which raised self-fulfilling fears about their solvency.

Two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (using a five-year rolling average valuation instead, for example) would have helped shore up the balance sheets of some banks. And a temporary easing of capital requirements would have given banks the breathing room to sort out the mortgage-backed security mess. Although it is hard to fix an exact price for these securities in this market, given that 98 percent of underlying mortgages are sound, they clearly aren't worth zero. (For more proposed solutions, see "Better Than a Bailout," page 30.)

Alas, the Fed and the Treasury Department, in full crisis mode, decided to provide their own capital to meet the regulatory requirements. The first misstep, in March, was to force a hostile takeover of Bear Stearns, putting up $30 billion to $40 billion to back J.P. Morgan's purchase of the distressed investment bank. In the long term, it probably would have been better to let Bear Stearns fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for mortgage-backed securities. From this established price, banks could have begun to sort out their balance sheets.

Immediately after the collapse of Bear Stearns, rumors circulated on Wall Street of trouble at another investment bank, Lehman Brothers. Lehman went on a P.R. offensive to beat back those rumors. The company was successful in the short term but then did nothing during the next several months to shore up its balance sheet. Its demise in September-the only major bankruptcy allowed during bailout season-was largely self-inflicted.

The collapse of the mortgage-backed security market now started to pollute other financial products. Collateralized debt obligations and credit default swaps are complicated financial products intended to help spread the risk of defaults. An investor holding a bond or mortgage-backed security may purchase one of these products so that, in the event the bond or mortgage-backed security defaults, they would recoup their investment. Bonds rarely default, so collateralized debt obligations and credit default swaps had traditionally been a fairly safe and conservative market.

But like the underlying bonds and mortgage-backed securities, these instruments became more exotic. Companies sold credit default swaps on an individual bond or security to multiple investors. If there was a default, each one of these investors would have to be paid up to the full amount of the bond or security. Imagine if you bought fire insurance on your house and all your neighbors did too. If your house burned, everyone would be compensated for the loss of your house.

Suddenly, stable firms such as AIG, which aggressively sold credit default swaps, were over-exposed. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but ironclad accounting regulations precluded this. So the government stepped in.

The Bailout

The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 spooked both Wall Street and the White House. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the weakness stemming from mortgage-backed securities would spread through the entire financial system. Money began leaving the markets to seek the security of Treasury bonds.

Then, on September 18, it was reported that the Reserve Primary Fund and the Reserve International Liquidity Fund, two commercial paper money market funds, "broke the buck," meaning they lost money. The commercial paper market is supposed to be boring. Every day, companies around the world borrow hundreds of billions to smooth cash flows; the next day they pay it back, giving the bank that lent the money a very small return. When these money market funds lost money, it was a signal that the commercial paper market was drying up, that banks were hesitant to make even these very safe loans.

That's when the market freaked out. The Dow Jones Industrial Average fell over 600 points on September 19. When the government announced that there would be a rescue plan, the market temporarily rebounded. After some details of the plan emerged over the weekend, the Dow had another selloff. A roller-coaster of selloffs and rallies followed, as the market waited to see what the government would do. Every gyration, up or down, was used as an argument for the bailout. If the market moved lower, it was because Congress hadn't approved the bailout. If it moved higher, it was because the market was convinced the bailout would happen. On October 2, after initially defeating the package, the House of Representatives bowed to pressure and passed it.

The original plan crafted by the Treasury Department would have authorized the government to spend up to $700 billion on mortgage-backed securities and other "toxic" debt, thereby removing them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the mortgage-backed security market was "illiquid," the government would become the buyer of last resort for these products. There was a certain simple elegance to the plan. To paraphrase H.L. Mencken, the solution was neat, plausible, and wrong.

No market is truly illiquid. Last summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' toxic debt, just not at the price the banks would prefer. Enter the government, which clearly intended to purchase mortgage-backed securities at some premium above the market price.

We don't know yet what the premium will be nor how it will be determined. Well, in a sense we do. It will mostly be determined by politics, not economics. This is the foundational flaw in the Treasury Department plan.

The department has begun a process to determine the assets it will buy and the manner it will set a price. As with everything in government, these are lobbyable moments, a time when swarms of financial service firms, investor groups, and housing advocates try to game the system for their clients or members. The further away from economics these decisions are made, the more risk there is for taxpayers. The higher the premium over any current market price, the longer the government will have to hold the assets and the more exposure there will be for taxpayers.

The risk here is particularly high given the complicated and opaque nature of the financial instruments involved. Few on Wall Street truly understand these products. The bailout authorizes the Treasury Department to bypass normal contracting rules and hire outside private firms to handle the purchases and manage the toxic assets. The fact that these private firms have ongoing relationships with the banks selling the bad assets creates a serious conflict of interest.

Some commentators have drawn parallels to the savings and loan bailout in the 1980s, when the government established the Resolution Trust Corporation to dispose of the assets of failed thrifts. But the Resolution Trust Corporation took on those assets only as thrifts went bankrupt. Under the new plan, by contrast, federal bureaucrats and their outside contractors decide which assets to buy, including equity stakes in commercial banks that aren't particularly happy about having Uncle Sam as a major shareholder. Bureaucrats will be actively investing taxpayer funds in individual securities and then managing the portfolio until they decide to sell. You don't have to be paranoid to fear the political dynamics that will shape these decisions.

More to Come

We have crossed a financial Rubicon. The bailout is just the beginning of Washington's increased involvement in the economy. The government has now taken partial ownership of the nation's nine largest banks. There is talk of bailouts for other weak industries, including the carmakers and the airlines. There certainly will be a host of new regulations that will likely be with us long after the government has sold off the last of the bad debt. We could be entering an era where the financial services sector evolves into a kind of regulated utility.

Libertarians used to joke that we were on the verge of another rerun of That '70s Show, with a return to old regulations and high taxation. We should be so lucky. The events of the last several months presage a return to the 1930s, with a new surge of direct federal involvement in the economy. If we fail to beat back these new controls, future historians may mark this time as the beginning of a long winter of statism and stagnation.

Mike Flynn is director of government affairs at the Reason Foundation.

We should be getting used to the depressing spectacle of once-great corporations begging for assistance from Washington. Yet perhaps nothing is more painful than to see General Motors and other big U.S.-based car companies – once exemplars of both American economic supremacy and middle-class aspirations – fall to such an appalling state.

Yet if GM represents all that is bad about the American economy, particularly manufacturing, it does not represent the breadth of our industrial landscape. Indeed, even as the dull-witted leviathan sinks, many nimble companies have shown remarkable resiliency.

These include a series of small and mid-sized firms – in fields as diverse as garments and agricultural machinery, steel and energy equipment – that have managed to thrive in recent years. It also includes a growing contingent of foreign-owned firms, notably in the automobile industry, that have found that "Made in America" is not necessarily uncompetitive, unprofitable or impossible.

Indeed, until the globalization of the financial crisis, American manufacturing exports were reaching record levels. Overall, U.S. industry has become among the most productive in the world – output has doubled over the past 25 years, and productivity has grown at a rate twice that of the rest of the economy. Far from dead, our manufacturing sector is the world's largest, with 5% of the world's population producing five times their share in industrial goods.

So what is the problem then? If it is not the effort and ingenuity of American workers or our infrastructure, Detroit's problems must lie somewhere else, largely with almost insanely bad management.

We have to remember that the Big Three have been losing market share through even the best of times. Their litany of excuses is as tiresome as their product lines. Back in the 1970s it was "cheap" Japanese labor, something that can no longer be cited as an excuse. European car makers, if anything, have even higher wage costs.

Then there is high gas prices – a good excuse, it appears, back in the 1970s, as well as more recently. But the Detroit auto industry has now had three decades to come up with fuel efficient products that are also fun to drive and reliable. While they have slumbered, the Japanese, Koreans and now the Europeans – with products like the new Volkswagen Jetta – have made enormous strides.

Now it is the credit crunch, the car makers say. OK. Will increased credit mean that people will suddenly scoop up the same products they have been deserting in droves for decades? Keep in mind that the desertion could get even worse if the congressional greens – led by new Energy and Commerce Committee Chairman Rep. Henry Waxman – impose stiffer taxes on gas, which will hurt the guzzlers that have generated most of Big Three profits.

So why the push to bail out the Big Three? It's basically about regional politics. The deindustrializing states of California and New York may not care much, but the big car companies' operations are overwhelmingly concentrated in the politically volatile Great Lakes region, an area that proved decisive in President-elect Obama's victory. Another big reason may be that up to 240,000 jobs in Illinois, the nation's new political epicenter, are tied to the big automakers.

Sadly, dependence on the Big Three has had long-term tragic results for this entire region. Between 2000 and 2007 – before the onset of the financial crisis – the nation's largest percentage losses of manufacturing jobs were concentrated in Big Three bastions like Detroit, Warren-Farmington Hills, Saginaw, Flint and Cleveland. In the five years before the onset of the financial crisis, Michigan alone had lost one-third of its auto manufacturing jobs. Now that figure is up to half.

Worse still has been the psychological dependency that has grown from this troubled relationship. By their very nature, declining businesses – particularly unionized ones – tend to protect their older members and encrusted bureaucracies more than they look to the future. This also creates a political environment where the incentive is not to spur innovation, but to protect the already established.

Michigan, for example, has met the challenge of its Big Three habit with a combination of farce and failure. Under the clueless leadership of its governor, Jennifer Granholm, the state first hoped its "cool cities" program would keep young, educated workers close to home. After that failed to work, the governor then pushed the highest tax boost in state history, a reliable job-killer.

So let us be clear. It did not take a world financial crisis to sink Michigan; it was getting there very well on its own. Nearly one in three residents, according to a July 2006 Detroit News poll, believe that Michigan is "a dying state." Two in five of the state's residents under 35 said they were seriously considering leaving the state.

Fortunately, the Big Three do not represent the entire picture of American manufacturing. Even within the Great Lakes region, Wisconsin, which ranks second in per capita employment in manufacturing, has held onto most of its industrial employment due to its large, highly diversified base of smaller-scale specialized manufacturers.

If Congress and President Obama want to figure out how to restart our industrial economy, they need to travel not to Detroit but to an alternative universe that includes the South and Appalachia, where most of the new foreign-owned auto manufacturers have clustered. States like Alabama, with the second-largest per capita concentration of auto-related jobs, as well as South Carolina, Tennessee, Kentucky, Georgia and Mississippi, have been growing these high-wage jobs for a new generation. In the process, they have brought unprecedented opportunity to some of the nation's historically poorest regions.

Nor are these states looking to remain mere assembly centers. For example, they have launched bold new research initiatives, such as the recently formed International Automotive Research Center at Clemson University, which offers the nation's only Ph.D. in automotive engineering, to make their region a major center of technological innovation for the industry. And the fact that the region will likely be producing the majority of the most low-mileage and low-emission cars certainly cannot hurt their future prospects.

However, it is also critical to see beyond merely autos. If you look at the period between 2000 and 2007, as we did at the Praxis Strategy Group, much of the fastest growth in manufacturing was taking place in areas tied to energy production like Midland and Longview, Texas, and Morgantown, W.Va., all of which enjoyed 15% or more increases in manufacturing jobs. Already states like Arkansas, Alabama, Iowa and Mississippi boast more per capita industrial jobs than either Michigan or Ohio.

Another strong performer has been the Great Plains. Places like Dubuque, Iowa, and Fargo and Grand Forks, N.D., experienced substantial growth in industrial jobs during the past decade. The base here, as in Wisconsin, is highly diverse and includes agricultural and construction equipment, electronics as well as a burgeoning sector in the renewable fuels sector, such as LM Glasfibre, a Danish firm with a large operation in Grand Forks. Washington state has been another bright spot, powered by Boeing and other manufacturers attracted to its low-cost, low-emission hydropower.

If the country is serious about enhancing U.S. industrial might – as it should be – it might want to ask executives and entrepreneurs in these areas, as well as foreign investors, what they need to keep growing and expanding exports. There is clearly a demonstrated global market for Boeing airplanes and Caterpillar construction and agricultural machinery, as well as a host of high-tech and fashion-related products now being churned out in factories scattered across the country.

The people running these firms should be those at the congressional hearings, not the pathetic losers from companies like General Motors. They might even have some helpful ideas, like streamlining regulations, investing in critical infrastructure and research facilities, expanding support for training a new generation of skilled blue collar workers and using incentives to encourage firms to improve their energy efficiency. These are the steps we can expect our competitors in Europe, Asia and the developing world to take as well.

Rather than looking for ways to bail out the most egregious serial failures, let us find ways to provide incentives for those successful at creating new jobs and saving existing ones.

This article originally appeared at Forbes.com.

Joel Kotkin is executive editor of NewGeography.com and is a presidential fellow in urban futures at Chapman University. He is author of The City: A Global History and is finishing a book on the American future.

So the big news today is that the governor of Illinois has been caught doing explicitly what most politicians do with more subtlety every single day: selling off their power to the highest bidder. I can't help but note that yet another politician is indicted on corruption charges at the very same time we are handing over unprecedented power to the political class as we partially nationalize the banking system and, apparently, the Big Three auto companies.

I simply do not understand how those who are in favor of giving government all of these new powers because they sincerely believe that doing so will work out the way their blackboard designs intended can keep a straight face. What kind of cognitive dissonance must it take to believe that the people YOU are handing power over to are "not like" Ted Stevens or Rod Blagojevich? How deeply must one be in denial or engage in rationalization to believe that they are "different?" How blind must one be to think that trillions of dollars in bailout money won't go to the highest bidder (as the lobbyists line up on K Street...) in a process different only in its wink-and-a-nod courtesies than Blagojevich's auctioning off of a Senate seat?

For me, the key insight of public choice is the same insight that underlies Austrian economics: it is the institutional framework that is the key to understanding the choices people make and the unintended outcomes they produce. As I said to a class last week: "Governments can't act like businesses because businesses only act like businesses because they operate in the institutional environment of private property, monetary exchange, and competition." In the same way, getting politicians to stop selling off their power isn't a matter of ethics or psychology, rather it's about changing the rules of the game such that they do not have as much power to sell. Unfortunately, the current bailout mania is changing those rules in utterly the wrong direction.

Look at it this way: the bailouts are already becoming just a legal form of the essentially the same behavior for which the governor has been indicted.

Henry Waxman's House Committee on Oversight and Government Reform met Tuesday to examine "The Role of Fannie Mae and Freddie Mac in the Financial Crisis." Alas, Mr. Waxman didn't come to bury Fan and Fred, but to bury the truth.

The two government-sponsored mortgage giants have long maintained they were merely unwitting victims of a financial act of God. That is, while the rest of the market went crazy over subprime and "liar" loans, Fan and Fred claimed to be the grownups of the mortgage market. There they were, the fable goes, quietly underwriting their 80% fixed-rate 30-year mortgages when -- Ka-Pow! -- they were blindsided by the greedy excesses of the subprime lenders who lacked their scruples.

But previously undisclosed internal documents that are now in Mr. Waxman's possession and that we've seen tell a different story. Memos and emails at the highest levels of Fannie and Freddie management in 2004 and 2005 paint a picture of two companies that saw their market share eroded by such products as option-ARMs and interest-only mortgages. The two companies were prepared to walk ever further out on the risk curve to maintain their market position.

The companies understood the risks they were running. But squeezed between the need to meet affordable-housing goals set by HUD and the desire to sustain their growth and profits, they took the leap anyway. As a result, by the middle of this year, the two companies were responsible for some $1.6 trillion worth of subprime credit of one form or another. The answer to Mr. Waxman's question about their role in the crisis, in other words, is that they were central players, if not the central players, in the creation of the housing boom and the credit bust. Mr. Waxman released some of these documents Tuesday but kept others under wraps.

In early 2004, Freddie's executive team was engaged in a heated debate over whether to start acquiring "stated income, stated assets" mortgages. And in April of that year, David Andrukonis, the head of risk management, wrote to his colleagues, "This is not an affordable product, as I understand it, but a product necessary to recapture [market] share. . . . In 1990 we called this product 'dangerous' and eliminated it from the marketplace." Freddie went ahead anyway.

At Tuesday's hearing, both Mr. Waxman and former Fannie CEO Franklin Raines argued that Fan and Fred were following the market, not leading it, as if this was exculpatory. The documents plainly show that people at both Fan and Fred clearly understood that these mortgages were risky, thought many homeowners didn't understand them and that they were putting their business at risk by buying up Alt-A and subprime mortgage-backed securities.

One Fannie Mae document from March 2005 notes dryly, "Although we invest almost exclusively in AAA-rated securities, there is a concern that the rating agencies may not be properly assessing the risk in these securities." But they bought them anyway, both to maintain their market share and to show people like Democrat Barney Frank that they were promoting affordable housing.

By April 2008, according to a document prepared for then-Fannie Mae CEO Daniel Mudd and marked "Confidential -- Highly Restricted," Fannie's $312 billion in Alt-A mortgages represented "12% of single-family credit exposure." This book of business, the document notes, "was originated to maintain relevance in market with customers -- main originators were Countrywide, Lehman, Indymac, Washington Mutual, Amtrust." The first four need no introduction; regulators ordered Ohio-based Amtrust to stop lending two weeks ago.

Remember that one of Fannie's roles was supposed to be to buy up mortgage-backed securities in the secondary market and keep that market "liquid." This was, they always argued, the rationale for their $1 trillion-plus MBS portfolios. By becoming buyers of private-label subprime and Alt-A-backed MBS, they did just that -- they liquified and helped legitimize products that they now claim others irresponsibly sold.

In today's Opinion Journal

REVIEW & OUTLOOK

Whitewashing Fannie MaePolitical Favors at the FCC

TODAY'S COLUMNIST

Wonder Land: U.S. Says It Will Bail Out Christmas – Daniel Henninger

COMMENTARY

We Need a Bailout Exit Strategy – Christopher CoxObama Was Mute on Illinois Corruption – John FundHow the GOP Should Prepare for a Comeback – Karl RoveBankruptcy Doesn't Equal Death – Don boudreauxMr. Raines even suggested that Fan and Fred's regulator was to blame for allowing them to get into trouble. "It is remarkable," he told the committee, "that during the period that Fannie Mae substantially increased its exposure to credit risk its regulator made no visible effort to enforce any limits."

What Mr. Raines failed to mention was that, all along, Fannie and Freddie were spending millions on lobbying to ensure that regulators did not get in their way. As the AP reported Sunday night, Freddie spent $11.7 million in lobbying in 2006 alone, with Newt Gingrich, for example, getting $300,000 that year for talking up the benefits of Freddie's business model. (Apologies welcome, Newt.)

Other Republicans on Freddie's payroll included former Senator Al D'Amato and Congressman Vin Weber, and then House Majority Leader Tom DeLay's former chief of staff, Susan Hirschmann. As we know by now, Fan and Fred tried to buy everybody in town from both political parties, and the companies did it well enough to make themselves immune from regulatory scrutiny.

Mr. Waxman calls it a "myth" that Fannie and Freddie were the originators of the crisis. That's a red herring. Mr. Waxman's documents prove beyond doubt that Fan and Fred turbocharged the housing mania with a taxpayer-backed, Congressionally protected business model that has cost America dearly.

And This Time We Didn't Even Get New Orleans!Matt Welch | December 15, 2008, 9:13amHow big is the $8.5 trillion bailout? According to James Bianco of the Chicago-based analysis firm Bianco Research, when you adjust previous mammoth Washington expenditures for inflation, the 2008 bailout dwarfs them all. Combined.

WSJBankruptcy Is the Perfect Remedy for Detroit Washington hates the idea because it would lose leverage.Article

By TODD J. ZYWICKIWhile Washington tries to arrange a bailout, the Detroit Three auto makers and their union, the United Auto Workers, keep insisting that bankruptcy would be the kiss of death. Not so: a Chapter 11 bankruptcy filing will likely result in a stronger domestic industry.

To understand why, consider that the fundamental question to ask of any firm facing bankruptcy is whether it is "economically failed" or simply "financially failed."

If a typewriter manufacturer were to file for bankruptcy today it likely would be considered an economically failed enterprise. The market for typewriters is small and shrinking, and the manufacturer's financial, physical and human capital would probably be better redeployed elsewhere, such as making computers.

A financially failed enterprise, on the other hand, is worth more alive than dead. Chapter 11 exists to allow it to continue in business while reorganizing. Reorganization arose in the late 19th century when creditors of railroads unable to meet their debt obligations threatened to tear up their tracks, melt them down, and sell the steel as scrap. But innovative judges, lawyers and businessmen recognized that creditors would collect more if they all agreed to reduce their claims and keep the railroads running and producing revenues to pay them off. The same logic animates Chapter 11 today.

General Motors looks like a financially failed rather than an economically failed enterprise -- in need of reorganization not liquidation. It needs to shed labor contracts, retirement contracts, and modernize its distribution systems by closing many dealerships. This will give rise to many current and future liabilities that may be worked out in bankruptcy. It may need new management as well. Bankruptcy provides an opportunity to do all that. Consumers have little to fear. Reorganization will pare the weakest dealers while strengthening those who remain.

So why do the Detroit Three managements and the UAW insist that "bankruptcy is not an option"? Perhaps because of the pain that would be inflicted upon both.

The bankruptcy code places severe limitations on the compensation that can be paid to a manager unless there is a "bona fide job offer from another business at the same or greater rate of compensation." Given the dismal performance of the Detroit Three in recent years, it seems unlikely that their senior management will be highly coveted on the open market. Incumbent management is also likely to find its prospects for continued employment less-secure.

Chapter 11 also provides a mechanism for forcing UAW workers to take further pay cuts, reduce their gold-plated health and retirement benefits, and overcome their cumbersome union work rules. The process for adjusting a collective bargaining agreement is somewhat complicated and begins with a sort of compulsory mediation process. But if this fails a company can (with court permission) nullify the agreement. This doomsday scenario is rarely triggered, however, as its threat casts a large shadow over negotiations, providing a stick to force concessions.

Those Washington politicians who repeat the mantra that "bankruptcy is not an option" probably do so because they want to use free taxpayer money to bribe Detroit into manufacturing the green cars favored by Nancy Pelosi and Harry Reid, rather than those cars American consumers want to buy. A Chapter 11 filing would remove these politicians' leverage, thus explaining their desperation to avoid a bankruptcy.

In short, Detroit and the public has little to fear from a bankruptcy filing, but much to fear from the corrupt bargain that is emerging among incumbent management, the UAW and Capitol Hill to spend our money to avoid their reality check.

Mr. Zywicki is a professor of law at George Mason University School of Law.

You know it doesn't matter. The unions have won.W who has sorely disappointed me here is caving because he doesn't want to be known as the President who allowed Detroit to fail. It is now all about his legacy.The left mocks him no matter what he does. Here is our leader literally being assaulted by that punk throwing shoes at him and I am outraged and agree he needs to do hard time. Could you imagine if he did that here in the US. Yet the left *laughs* and sides with the Iraqi punk. They already joke he will get a stint in Hollywood.

This newsman must have been in Saddams party and pissed his little group of thugs can't go around looting, raping, and shoving everyone else around. The Iraqis should be thanking us from saving them from that butcher. Some probably do but we never hear them. As always the MSM goes for those that complain about America because that is what they think - that America is to blame.

In the past 10 years, under both Republican and Democratic governors, legislative Democrats have presided over a doubling of the California budget, from $72 billion in 1998 to $145 billion. This is double the rate of population and inflation growth, and it is unsustainable.

How unsustainable? California may have a $42 billion deficit over the next 18 months, an astonishing 30% of revenue expected just a few months earlier. California may run out of cash by the end of February, causing state financial officials to vote on Wednesday to halt $4 billion in construction spending. A California bond maturing in 30 years yields about 6.89% — 1.8 percentage points more than three months ago.

California has the nation's highest income taxes, the highest state sales tax rate, the highest gas tax and the highest corporate tax in the western U.S. And contrary to popular mythology about Proposition 13 (passed by the voters in 1978), the state's property taxes are at the national average.

Forbes magazine ranks California as having the highest business costs (taking into account taxes, labor and energy). The Tax Foundation ranks California as having the 48th worst business-tax climate, down from 38th just three years earlier. Only New Jersey and New York are assessed as more hostile to business.

Clearly, California does not have a yawning budget deficit because of a light, business-friendly tax burden. California has a spending problem, not a revenue problem.

Yet, in spite of all the overspending, majority Democrats are only offering one-time reductions in the spending of $8 billion. There is no talk of government reform without which any solution would last no more than a year.

California has America's most generous welfare rules. We have not fully implemented the historic welfare-to-work reforms signed into law by President Clinton in 1996, risking federal sanctions as a result. California even spends hundreds of millions of dollars on optional benefits for those in the U.S. illegally. Some state health and welfare programs are growing at a 7%-8% annual clip, with no letup in sight.

Further, California's heavy-handed regulations act as a hidden, added tax on productivity. For instance, California regulates 177 occupations, nearly twice the national average, forcing many residents to pay fees, take tests, and get additional schooling just to put food on the table.

California's housing regulations shackled urban homeowners with added costs of $2.7 trillion, according to one 2006 study by the Reason Foundation, accounting for almost half of the entire nation's regulatory burden of $5.5 trillion. Restrictions on drilling for oil keep over a billion barrels of crude in state coastal waters off-limits to even slant drilling from inland areas, taking a billion dollars a year in royalties off the table.

Gov. Schwarzenegger has rightly called for an easing of the regulatory burden, both environmental and labor laws, to stimulate the sagging economy. Unfortunately, the greatest new regulatory costs have been championed by the governor himself, with new global warming and renewable energy rules set to add about $1,700 in annual costs for a California family of four over the next 10 years.

With an 8.2% unemployment rate, America's third-highest, California workers are likely to see far greater pain in the months ahead as lawmakers resist reducing taxes on capital and wealth generation, and instead seek to increase taxes by $11 billion over the next 18 months.

This includes a 2.5% income-tax surcharge, a 10% increase in sales tax collections by increasing the base rate from 7.25% to 8%, and a $2.1 billion increase in the gasoline tax and others — all on top of what are already the nation's highest income, sales and gas taxes.

There are two problems with this massive Democratic tax increase plan: It will throw more working Californians into the unemployment line, and it's unconstitutional.

In 1978, California voters kicked off a national tax revolt by passing Proposition 13, and in the process boosting the political career of a former California governor by the name of Ronald Reagan. Proposition 13 created Article XIII of the state constitution, which says the legislature cannot raise taxes except by a two-thirds majority vote in each house.Democrats are a few votes short of two-thirds in each house, giving Republicans, who understand that increasing taxes in this economic climate is tantamount to economic suicide, leverage to call for government reform.

At this writing, Democrats may give the governor some regulatory reforms in the hope that he will sign their illegal $11 billion tax increase. Legislative Republicans encourage Gov. Schwarzenegger to veto the package and uphold his oath to defend the constitution while defending the hardworking taxpayers of the Golden State.

DeVore, a California state assemblyman (R-Irvine), is also a candidate for the U.S. Senate in 2010.

A week-plus ago I posted some data compiled by Bianco Research analyst James Bianco indicating that our $8.4 trillion-and-counting bailout dwarfs just about every huge government project you can think of, combined. Reader domoarrigato argued that re-casting those numbers as a percentage of their contemporaneous GDP might be more illuminating, and then he went ahead and did the math himself. After sending the informatics to our top experts, we are now prepared to publish them in a hopefully easy-on-the-eyes chart. Here goes:

Speaking of bailout graphics, try this more colorful one from Pro Publica–a bubble-chart of post-1970 bailouts, adjusted for 2008 dollars (though not as a percentage of GDP!).

A tangential topic for discussion: What do you all think of the argument that percent-of-GDP is the real way one should ponder stuff like the size of various government programs, or defense spending, or the whole state apparatus itself? I've always thought it extremely helpful for personal context (thanks again, domoarrigato!), and extremely dangerous for the purposes of deciding how to spend.

Here's why: The biggest chunk of GDP, and certainly the most dynamic, is the stuff produced by the private sector. Pegging a public-sector program to a private-sector number basically rewards inefficient non-innovators with the innovators' gains. Put another way, if it cost 4 shekels a year to adequately defend a country with a 100-shekel economy (let's say that 77 of those 100 shekels were produced by the private sector), why on earth should we increase the defense budget to 8 shekels when (as inevitably happens) the profit-seeking privates double their money? I understand that labor and materials can become more expensive in a growing economy, thus adding costs to guvmint operations, but essentially this is about making the booming size of government look rational, just because the private sector is (or was) booming as well. Where am I wrong here?

“Usually it’s the rich country lending to the poor. This time, it’s the poor country lending to the rich.” — Niall Ferguson

WASHINGTON — In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.

The problem, he said, was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.

This colossal credit cycle could not last forever, he said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, “we probably have little choice except to be patient.”

Today, the dependence of the United States on Chinese money looks less benign. And the economist who proposed the theory, Ben S. Bernanke, is dealing with the consequences, having been promoted to chairman of the Fed in 2006, as these cross-border money flows were reaching stratospheric levels.

In the past decade, China has invested upward of $1 trillion, mostly earnings from manufacturing exports, into American government bonds and government-backed mortgage debt. That has lowered interest rates and helped fuel a historic consumption binge and housing bubble in the United States.

China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways.

“This was a blinking red light,” said Kenneth S. Rogoff, a professor of economics at Harvard and a former chief economist at the International Monetary Fund. “We should have reacted to it.”

In hindsight, many economists say, the United States should have recognized that borrowing from abroad for consumption and deficit spending at home was not a formula for economic success. Even as that weakness is becoming more widely recognized, however, the United States is likely to be more addicted than ever to foreign creditors to finance record government spending to revive the broken economy.

To be sure, there were few ready remedies. Some critics argue that the United States could have pushed Beijing harder to abandon its policy of keeping the value of its currency weak — a policy that made its exports less expensive and helped turn it into the world’s leading manufacturing power. If China had allowed its currency to float according to market demand in the past decade, its export growth probably would have moderated. And it would not have acquired the same vast hoard of dollars to invest abroad.

Others say the Federal Reserve and the Treasury Department should have seen the Chinese lending for what it was: a giant stimulus to the American economy, not unlike interest rate cuts by the Fed. These critics say the Fed under Alan Greenspan contributed to the creation of the housing bubble by leaving interest rates too low for too long, even as Chinese investment further stoked an easy-money economy. The Fed should have cut interest rates less in the middle of this decade, they say, and started raising them sooner, to help reduce speculation in real estate.

Today, with the wreckage around him, Mr. Bernanke said he regretted that more was not done to regulate financial institutions and mortgage providers, which might have prevented the flood of investment, including that from China, from being so badly used. But the Fed’s role in regulation is limited to banks. And stricter regulation by itself would not have been enough, he insisted.

“Achieving a better balance of international capital flows early on could have significantly reduced the risks to the financial system,” Mr. Bernanke said in an interview in his office overlooking the Washington Mall.

“However,” he continued, “this could only have been done through international cooperation, not by the United States alone. The problem was recognized, but sufficient international cooperation was not forthcoming.”

The inaction was because of a range of factors, political and economic. By the yardsticks that appeared to matter most — prosperity and growth — the relationship between China and the United States also seemed to be paying off for both countries. Neither had a strong incentive to break an addiction: China to strong export growth and financial stability; the United States to cheap imports and low-cost foreign loans.

In Washington, China was treated as a threat by some people, but mostly because it lured away manufacturing jobs. Others argued that China’s heavy lending to this country was risky because Chinese leaders could decide to withdraw money at a moment’s notice, creating a panicky run on the dollar.

Mr. Bernanke viewed such international investment flows through a different lens. He argued that Chinese invested savings abroad because consumers in China did not have enough confidence to spend. Changing that situation would take years, and did not amount to a pressing problem for the Americans.

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“The global savings glut story did us a collective disservice,” said Edwin M. Truman, a former Fed and Treasury official. “It created the idea that the world was doing it to us and we couldn’t do anything about it.”

But Mr. Bernanke’s theory fit the prevailing hands-off, pro-market ideology of recent years. Mr. Greenspan and the Bush administration treated the record American trade deficit and heavy foreign borrowing as an abstract threat, not an urgent problem.

Mr. Bernanke, after he took charge of the Fed, warned that the imbalances between the countries were growing more serious. By then, however, it was too late to do much about them. And the White House still regarded imbalances as an arcane subject best left to economists.

By itself, money from China is not a bad thing. As American officials like to note, it speaks to the attractiveness of the United States as a destination for foreign investment. In the 19th century, the United States built its railroads with capital borrowed from the British.

In the past decade, China arguably enabled an American boom. Low-cost Chinese goods helped keep a lid on inflation, while the flood of Chinese investment helped the government finance mortgages and a public debt of close to $11 trillion.

But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads. Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and larger homes. Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralized debt obligations.

“Nobody wanted to get off this drug,” said Senator Lindsey Graham, the South Carolina Republican who pushed legislation to punish China by imposing stiff tariffs. “Their drug was an endless line of customers for made-in-China products. Our drug was the Chinese products and cash.”

Mr. Graham said he understood the addiction: he was speaking by phone from a Wal-Mart store in Anderson, S.C., where he was Christmas shopping in aisles lined with items from China.

A New Economic Dance

The United States has been here before. In the 1980s, it ran heavy trade deficits with Japan, which recycled some of its trading profits into American government bonds.

At that time, the deficits were viewed as a grave threat to America’s economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world’s major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the Japanese yen for halting Japan’s rapid growth. The lesson of the Plaza Accord was not lost on China, which at that time was just emerging as an export power.

China tied itself even more tightly to the United States than did Japan. In 1995, it devalued its currency and set a firm exchange rate of roughly 8.3 to the dollar, a level that remained fixed for a decade.

During the Asian financial crisis of 1997-98, China clung firmly to its currency policy, earning praise from the Clinton administration for helping check the spiral of devaluation sweeping Asia. Its low wages attracted hundreds of billions of dollars in foreign investment.

By the early part of this decade, the United States was importing huge amounts of Chinese-made goods — toys, shoes, flat-screen televisions and auto parts — while selling much less to China in return.

“For consumers, this was a net benefit because of the availability of cheaper goods,” said Laurence H. Meyer, a former Fed governor. “There’s no question that China put downward pressure on inflation rates.”

But in classical economics, that trade gap could not have persisted for long without bankrupting the American economy. Except that China recycled its trade profits right back into the United States.

It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save in the state-run banking system most foreign currency — primarily dollars — that they earned from foreign trade and investment.

As foreign trade surged, this hoard of dollars became enormous. In 2000, the reserves were less than $200 billion; today they are about $2 trillion.

Chinese leaders chose to park the bulk of that in safe securities backed by the American government, including Treasury bonds and the debt of Fannie Mae and Freddie Mac, which had implicit government backing.

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Dollar Shift: Chinese Pockets Filled as Americans’ Emptied

published: December 25, 2008

(Page 3 of 3)

This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for United States securities, it also helped push interest rates below where they would otherwise have been. For years, China’s government was eager to buy American debt at yields many in the private sector felt were too low.

This financial and trade embrace between the United States and China grew so tight that Niall Ferguson, a financial historian, has dubbed the two countries Chimerica.‘Tiptoeing’ Around a Partner

Being attached at the hip was not entirely comfortable for either side, though for widely differing reasons.

In the United States, more people worried about cheap Chinese goods than cheap Chinese loans. By 2003, China’s trade surplus with the United States was ballooning, and lawmakers in Congress were restive. Senator Graham and Senator Charles E. Schumer, Democrat of New York, introduced a bill threatening to impose a 27 percent duty on Chinese goods.

“We had a moment where we caught everyone’s attention: the White House and China,” Mr. Graham recalled.

At the People’s Bank of China, the central bank, a consensus was also emerging in late 2004: China should break its tight link to the dollar, which would make its exports more expensive. Yu Yongding, a leading economic adviser, pressed the case. The American trade and budget deficits were not sustainable, he warned. China was wrong to keep its currency artificially depressed and depend too much on selling cheap goods.

Proponents of revaluation in China argued that the country’s currency policies denied the fruits of prosperity to Chinese consumers. Beijing was investing their savings in low-yielding American government securities. And with a weak currency, they said, Chinese could not afford many imported goods.

The central bank’s English-speaking governor, Zhou Xiaochuan, was among those who favored a sizable revaluation.

But when Beijing acted to amend its currency policy in 2005, under heavy pressure from Congress and the White House, it moved cautiously. The renminbi was allowed to climb only 2 percent. The Communist Party opted for only incremental adjustments to its economic model after a decade of fast growth. Little changed: China’s exports kept soaring and investment poured into steel mills and garment factories.

But American officials eased the pressure. They decided to put more emphasis on urging Chinese consumers to spend more of their savings, which they hoped would eventually bring the two economies into better balance. On a tour of China, John W. Snow, the Treasury secretary at the time, even urged the Chinese to start using credit cards.

China kicked off its own campaign to encourage domestic consumption, which it hoped would provide a new source. But Chinese save with the same zeal that, until recently, Americans spent. Shorn of the social safety net of the old Communist state, they squirrel away money to pay for hospital visits, housing or retirement. This accounts for the savings glut identified by Mr. Bernanke.

Privately, Chinese officials confided to visiting Americans that the effort was not achieving much.

“It is sometimes hard to change successful models,” said Robert B. Zoellick, who negotiated with the Chinese as a deputy secretary of state. “It is prototypically American to say, ‘This worked well, but now you’ve got to change it.’ ”

In Washington, some critics say too little was done. A former Treasury official, Timothy D. Adams, tried to get the I.M.F. to act as a watchdog for currency manipulation by China, which would have subjected Beijing to more global pressure.

Yet when Mr. Snow was succeeded as Treasury secretary by Henry M. Paulson Jr. in 2006, the I.M.F. was sidelined, according to several officials, and Mr. Paulson took command of China policy.

He was not shy about his credentials. As an investment banker with Goldman Sachs, Mr. Paulson made 70 trips to China. In his office hangs a watercolor depicting the hometown of Zhu Rongji, a forceful former prime minister.

“I pushed very hard on currency because I believed it was important for China to get to a market-determined currency,” Mr. Paulson said in an interview. But he conceded he did not get what he wanted.

In late 2006, Mr. Paulson invited Mr. Bernanke to accompany him to Beijing. Mr. Bernanke used the occasion to deliver a blunt speech to the Chinese Academy of Social Sciences, in which he advised the Chinese to reorient their economy and revalue their currency.

At the last minute, however, Mr. Bernanke deleted a reference to the exchange rate being an “effective subsidy” for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China.

Critics detected a pattern. They noted that in its twice-yearly reports to Congress about trading partners, the Treasury Department had never branded China a currency manipulator.

“We’re tiptoeing around, desperately trying not to irritate or offend the Chinese,” said Thea M. Lee, public policy director of the A.F.L.-C.I.O. “But to get concrete results, you have to be confrontational.”

An Embrace That Won’t Let Go

For China, too, this crisis has been a time of reckoning. Americans are buying fewer Chinese DVD players and microwave ovens. Trade is collapsing, and thousands of workers are losing their jobs. Chinese leaders are terrified of social unrest.

Having allowed the renminbi to rise a little after 2005, the Chinese government is now under intense pressure domestically to reverse course and depreciate it. China’s fortunes remain tethered to those of the United States. And the reverse is equally true.

In a glassed-in room in a nondescript office building in Washington, the Treasury conducts nearly daily auctions of billions of dollars’ worth of government bonds. An old Army helmet sits on a shelf: as a lark, Treasury officials have been known to strap it on while they monitor incoming bids.

For the past five years, China has been one of the most prolific bidders. It holds $652 billion in Treasury debt, up from $459 billion a year ago. Add in its Fannie Mae bonds and other holdings, and analysts figure China owns $1 of every $10 of America’s public debt.

The Treasury is conducting more auctions than ever to finance its $700 billion bailout of the banks. Still more will be needed to pay for the incoming Obama administration’s stimulus package. The United States, economists say, will depend on the Chinese to keep buying that debt, perpetuating the American habit.

Even so, Mr. Paulson said he viewed the debate over global imbalances as hopelessly academic. He expressed doubt that Mr. Bernanke or anyone else could have solved the problem as it was germinating.

“One lesson that I have clearly learned,” said Mr. Paulson, sitting beneath his Chinese watercolor. “You don’t get dramatic change, or reform, or action unless there is a crisis.”

There's No Pain-Free Cure for RecessionBelt-tightening is required by all, including government.

By PETER SCHIFF

As recession fears cause the nation to embrace greater state control of the economy and unimaginable federal deficits, one searches in vain for debate worthy of the moment. Where there should be an historic clash of ideas, there is only blind resignation and an amorphous queasiness that we are simply sweeping the slouching beast under the rug.

With faith in the free markets now taking a back seat to fear and expediency, nearly the entire political spectrum agrees that the federal government must spend whatever amount is necessary to stabilize the housing market, bail out financial firms, liquefy the credit markets, create jobs and make the recession as shallow and brief as possible. The few who maintain free-market views have been largely marginalized.

Taking the theories of economist John Maynard Keynes as gospel, our most highly respected contemporary economists imagine a complex world in which economics at the personal, corporate and municipal levels are governed by laws far different from those in effect at the national level.

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Individuals, companies or cities with heavy debt and shrinking revenues instinctively know that they must reduce spending, tighten their belts, pay down debt and live within their means. But it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system. In their view, absent the stimuli of the New Deal and World War II, the Depression would never have ended.

On a gut level, we have a hard time with this concept. There is a vague sense of smoke and mirrors, of something being magically created out of nothing. But economics, we are told, is complicated.

It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid. However, this is precisely what we are planning on a national level.

I believe these ideas hold sway largely because they promise happy, pain-free solutions. They are the economic equivalent of miracle weight-loss programs that require no dieting or exercise. The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice.

As a follower of the Austrian School of economics I believe that market forces apply equally to people and nations. The problems we face collectively are no different from those we face individually. Belt tightening is required by all, including government.

Governments cannot create but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn't have a surplus, then it must come from taxes. If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing.

Similarly, any jobs or other economic activity created by public-sector expansion merely comes at the expense of jobs lost in the private sector. And if the government chooses to save inefficient jobs in select private industries, more efficient jobs will be lost in others. As more factors of production come under government control, the more inefficient our entire economy becomes. Inefficiency lowers productivity, stifles competitiveness and lowers living standards.

If we look at government market interventions through this pragmatic lens, what can we expect from the coming avalanche of federal activism?

By borrowing more than it can ever pay back, the government will guarantee higher inflation for years to come, thereby diminishing the value of all that Americans have saved and acquired. For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation.

The good news is that economics is not all that complicated. The bad news is that our economy is broken and there is nothing the government can do to fix it. However, the free market does have a cure: it's called a recession, and it's not fun, easy or quick. But if we put our faith in the power of government to make the pain go away, we will live with the consequences for generations.

Mr. Schiff is president of Euro Pacific Capital and author of "The Little Book of Bull Moves in Bear Markets" (Wiley, 2008).

Start this by noting Crafty's reference to Jude Wanniski's book and Guiness' Nov. post regarding 5 myths of the great depression. I heard a television commentator, I think it was an Obama adviser, saying that the reason the great depression won't be repeated is because we don't suffer from the same economic ignorance of the 1920s-1930s... I beg to differ.

This piece, "A tale of two pundits: Sowell v. Huffington" by Roger Kimballhttp://www.pajamasmedia.com/rogerkimball/2008/12/23/a-tale-of-two-pundits-sowell-v-huffington/?print=1takes a look at 2 sides of an important argument. He links and quotes Ariana Huffington who perpetuates the myth that the great depression was the result of the failure of free market capitalism. Then he contrasts that with a counter-view from Thomas Sowell that the economy could have survived the financial crash if not for the blundering of the government policies that followed, perpetuating, worsening and deepening the economic damage.

So here we are again, trying in every way possible to block the market forces that strive to correct the prices of assets and allow the flow of resources to their most productive use.-------------------------December 23, 2008Another Great Depression?By Thomas Sowell

With both Barack Obama's supporters and the media looking forward to the new administration's policies being similar to President Franklin D. Roosevelt's policies during the 1930s depression, it may be useful to look at just what those policies were and-- more important-- what their consequences were.

The prevailing view in many quarters is that the stock market crash of 1929 was a failure of the free market that led to massive unemployment in the 1930s-- and that it was intervention of Roosevelt's New Deal policies that rescued the economy.

It is such a good story that it seems a pity to spoil it with facts. Yet there is something to be said for not repeating the catastrophes of the past.

Let's start at square one, with the stock market crash in October 1929. Was this what led to massive unemployment?

Official government statistics suggest otherwise. So do new statistics on unemployment by two current scholars, Richard Vedder and Lowell Gallaway, in their book "Out of Work."

The Vedder and Gallaway statistics allow us to follow unemployment month by month. They put the unemployment rate at 5 percent in November 1929, a month after the stock market crash. It hit 9 percent in December-- but then began a generally downward trend, subsiding to 6.3 percent in June 1930.

That was when the Smoot-Hawley tariffs were passed, against the advice of economists across the country, who warned of dire consequences.

Five months after the Smoot-Hawley tariffs, the unemployment rate hit double digits for the first time in the 1930s.

This was more than a year after the stock market crash. Moreover, the unemployment rate rose to even higher levels under both Presidents Herbert Hoover and Franklin D. Roosevelt, both of whom intervened in the economy on an unprecedented scale.

Before the Great Depression, it was not considered to be the business of the federal government to try to get the economy out of a depression. But the Smoot-Hawley tariff-- designed to save American jobs by restricting imports-- was one of Hoover's interventions, followed by even bigger interventions by FDR.

The rise in unemployment after the stock market crash of 1929 was a blip on the screen compared to the soaring unemployment rates reached later, after a series of government interventions.

For nearly three consecutive years, beginning in February 1932, the unemployment rate never fell below 20 percent for any month before January 1935, when it fell to 19.3 percent, according to the Vedder and Gallaway statistics.

In other words, the evidence suggests that it was not the "problem" of the financial crisis in 1929 that caused massive unemployment but politicians' attempted "solutions." Is that the history that we seem to be ready to repeat?

The stock market crash, which has been blamed for the widespread suffering during the Great Depression of the 1930s, created no unemployment rate that was even half of what was created in the wake of the government interventions of Hoover and FDR.

Politically, however, Franklin D. Roosevelt could not have been more successful. After all, he was the only President of the United States elected four times in a row. He was a master of political rhetoric.

If Barack Obama wants political success, following in the footsteps of FDR looks like the way to go. But people who are concerned about the economy need to take a closer look at history. We deserve something better than repeating the 1930s disasters.

There is yet another factor that provides a parallel to what happened during the Great Depression. No matter how much worse things got after government intervention under Roosevelt's New Deal policies, the party line was that he had to "do something" to get us out of the disaster created by the failure of the unregulated market and Hoover's "do nothing" policies.

Today, increasing numbers of scholars recognize that FDR's own policies were a further extension of interventions begun under Hoover. Moreover, the temporary rise in unemployment after the stock market crash was nowhere near the massive and long-lasting unemployment after government interventions.

Barack Obama already has his Herbert Hoover to blame for any and all disasters that his policies create: George W. Bush.

MADISON, Wis. - Five Democratic governors are asking the federal government for a $1 trillion bailout package, including $250 billion for education and $150 billion in middle class tax cuts.

The governors from Wisconsin, Massachusetts, New Jersey, New York and Ohio on Friday said they have presented their plan to President-elect Barack Obama’s transition team as well as congressional leaders.

They said that level of federal aid is needed to deal with unprecedented state budget shortfalls in 41 states and Washington, D.C., that the Center on Budget and Policy Priorities pegged at $42 billion for the current fiscal year alone.

Wisconsin Gov. Jim Doyle said congressional leaders and the Obama team have been receptive to the governors’ ideas.

"That’s not to say they’ve told us this is what they’ll do or they’re with us all the way," Doyle said. He also said other governors were involved in creating the plan, which grew out of an early December meeting that Obama had with the nation’s governors.

Obama’s aides and congressional leaders have been talking about a package roughly half the size of the two-year plan the five governors proposed Friday.

A $1 trillion package is equal to 6.7 percent of the gross domestic product, the U.S. economy’s total output in a single year. A package of that size is likely to draw significant opposition from congressional Republicans and concern from moderate and conservative Democratic lawmakers who oppose large budget deficits.

In addition to the money for education and tax cuts, the governors said their plan includes $250 billion for social service programs such as Medicaid and $350 billion for road construction and other infrastructure projects.

"The idea is to put people to work and to put them to work in ways that build on a stronger, long-term economic platform for future growth," said Massachusetts Gov. Deval Patrick. "Any economic recovery bill in our view passed by Congress should be bold enough to have a psychological impact and well as an economic one."

The governors all said their states are facing unprecedented budget shortfalls that will require deep cuts to services and possibly irreparably harm their education systems.

Ohio’s budget deficit could grow to $7.3 billion even after $1.9 billion was cut from its current budget, Strickland said.

In Massachusetts, Patrick has already made $1.1 billion in budget cuts and said Tuesday an additional $1 billion in cuts may be needed in what started as a $28.1 billion budget for the 2008-2009 fiscal year.

New York Gov. David Paterson said his state faces a $15.4 billion deficit. Wisconsin’s budget is expected to be $5.4 billion short by mid-2011.

New Jersey Gov. John Corzine said he had just left a meeting with state legislative leaders where he proposed $2.1 billion in cuts on top of $600 million that’s already been cut from the budget.

Strickland said the federal stimulus is needed to help bridge the gap from the current recession to when there’s a rebound. Even with the money, states will have to make deep cuts, he said.

"We are not, any of us, talking about federal money to expand spending, expand programs, to do new things," Patrick said.

A forecast from Global Insight shows that the economy hasn’t hit bottom yet.

National economic growth is now expected to drop 1.8 percent this year, rather than increase 1 percent. The U.S. labor market is expected to lose 3.7 million jobs during the downturn, with unemployment reaching 8.7 percent in the first half of 2010, it said.

That forecast assumes there will be a $550 billion federal stimulus package, roughly half of what the governors requested.

Is there any hard proof (besides the author quoted) that solutions other than Roosevelt's would have worked to turn around the economy? I'm talking about non-editorial, researched data.

Don't know about a source, but I think the question contain a false premise, specifically that Roosevelt's policies turned the economy around. Most of the reading I've done suggest WWII industrial production had far more to do w/ it.

Edited to add:

I see Amazon lists this book:

FDR's Folly: How Roosevelt and His New Deal Prolonged the Great Depression

Product Description“Admirers of FDR credit his New Deal with restoring the American economy after the disastrous contraction of 1929—33. Truth to tell–as Powell demonstrates without a shadow of a doubt–the New Deal hampered recovery from the contraction, prolonged and added to unemployment, and set the stage for ever more intrusive and costly government. Powell’s analysis is thoroughly documented, relying on an impressive variety of popular and academic literature both contemporary and historical.”–Milton Friedman, Nobel Laureate, Hoover Institution

“There is a critical and often forgotten difference between disaster and tragedy. Disasters happen to us all, no matter what we do. Tragedies are brought upon ourselves by hubris. The Depression of the 1930s would have been a brief disaster if it hadn’t been for the national tragedy of the New Deal. Jim Powell has proven this.”–P.J. O’Rourke, author of Parliament of Whores and Eat the Rich

“The material laid out in this book desperately needs to be available to a much wider audience than the ranks of professional economists and economic historians, if policy confusion similar to the New Deal is to be avoided in the future.”–James M. Buchanan, Nobel Laureate, George Mason University

“I found Jim Powell’s book fascinating. I think he has written an important story, one that definitely needs telling.”–Thomas Fleming, author of The New Dealers’ War

“Jim Powell is one tough-minded historian, willing to let the chips fall where they may. That’s a rare quality these days, hence more valuable than ever. He lets the history do the talking.”–David Landes, Professor of History Emeritus, Harvard University

“Jim Powell draws together voluminous economic research on the effects of all of Roosevelt’s major policies. Along the way, Powell gives fascinating thumbnail sketches of the major players. The result is a devastating indictment, compellingly told. Those who think that government intervention helped get the U.S. economy out of the depression should read this book.”–David R. Henderson, editor of The Fortune Encyclopedia of Economics and author of The Joy of Freedom

The Great Depression and the New Deal. For generations, the collective American consciousness has believed that the former ruined the country and the latter saved it. Endless praise has been heaped upon President Franklin Delano Roosevelt for masterfully reining in the Depression’s destructive effects and propping up the country on his New Deal platform. In fact, FDR has achieved mythical status in American history and is considered to be, along with Washington, Jefferson, and Lincoln, one of the greatest presidents of all time. But would the Great Depression have been so catastrophic had the New Deal never been implemented?

In FDR’s Folly, historian Jim Powell argues that it was in fact the New Deal itself, with its shortsighted programs, that deepened the Great Depression, swelled the federal government, and prevented the country from turning around quickly. You’ll discover in alarming detail how FDR’s federal programs hurt America more than helped it, with effects we still feel today, including:

• How Social Security actually increased unemployment• How higher taxes undermined good businesses• How new labor laws threw people out of work• And much more

This groundbreaking book pulls back the shroud of awe and the cloak of time enveloping FDR to prove convincingly how flawed his economic policies actually were, despite his good intentions and the astounding intellect of his circle of advisers. In today’s turbulent domestic and global environment, eerily similar to that of the 1930s, it’s more important than ever before to uncover and understand the truth of our history, lest we be doomed to repeat it.

From BooklistIts duration and depth made the Depression "Great," and Shlaes, a prominent conservative economics journalist, considers why a decade of government intervention ameliorated but never tamed it. With vitality uncommon for an economics history, Shlaes chronicles the projects of Herbert Hoover and Franklin Roosevelt as well as these projects' effect on those who paid for them. Reminding readers that the reputedly do-nothing Hoover pulled hard on the fiscal levers (raising tariffs, increasing government spending), Shlaes nevertheless emphasizes that his enthusiasm for intervention paled against the ebullient FDR's glee in experimentation. She focuses closely on the influence of his fabled Brain Trust, her narrative shifting among Raymond Moley, Rexford Tugwell, and other prominent New Dealers. Businesses that litigated their resistance to New Deal regulations attract Shlaes' attention, as do individuals who coped with the despair of the 1930s through self-help, such as Alcoholics Anonymous cofounder Bill Wilson. The book culminates in the rise of Wendell Willkie, and Shlaes' accent on personalities is an appealing avenue into her skeptical critique of the New Deal. Gilbert Taylor

Generally I agree with BBG's comments. The best explanation I have read of the Great Depression can be found in Jude Wanniski's "The Way the World Works".

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Another clusterfcuk cometh:

Mortgage 'Cram-Downs' Loom as Foreclosures Mount

Mortgage lenders who wake up Thursday with a New Year's hangover are likely to face another headache soon: The effort to give bankruptcy judges the power to rewrite mortgages is gaining steam.The banking industry hoped the mortgage "cram-down" measure died when Congress removed it from the $700 billion bailout bill that passed in October. But it has been gathering momentum in Democrat-controlled Washington, as evidence emerges that current voluntary foreclosure-prevention programs are falling short.In a cram-down, a judge modifies a loan, often reducing principal so a borrower can afford it. Lenders hate it because they have to absorb ...http://online.wsj.com/article/SB123068005350543971.html

By JONATHAN WEISMAN and NAFTALI BENDAVIDWASHINGTON -- President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

The size of the proposed tax cuts -- which would account for about 40% of a stimulus package that could reach $775 billion over two years -- is greater than many on both sides of the aisle in Congress had anticipated. It may make it easier to win over Republicans who have stressed that any initiative should rely more heavily on tax cuts rather than spending.

The Obama tax-cut proposals, if enacted, could pack more punch in two years than either of President George W. Bush's tax cuts did in their first two years. Mr. Bush's 10-year, $1.35 trillion tax cut of 2001, considered the largest in history, contained $174 billion of cuts during its first two full years, according to Congress's Joint Committee on Taxation. The second-largest tax cut -- the 10-year, $350 billion package engineered by Mr. Bush in 2003 -- contained $231 billion in 2004 and 2005.

Republicans and business leaders hadn't seen specifics of the proposals Sunday night, but welcomed the idea of basing a bigger proportion of the stimulus plan on tax cuts. Their response suggests the legislation could attract relatively broad support, and it highlighted the Obama team's determination to win backing from varied interests.

The largest piece of tax relief in the new plan would involve cuts for people who pay income taxes or who claim the earned-income credit, a refund designed to lessen the impact of payroll taxes on low- and moderate-income workers. This component would serve as a down payment on the "Making Work Pay" proposal Mr. Obama outlined during his election campaign, giving a credit of $500 per individual or $1,000 per family.

On the campaign trail, Mr. Obama said he would phase out a similar tax-credit proposal at around $200,000 per household, but aides said they haven't settled on an income cap for the latest proposal. This part of the plan is similar to a bipartisan initiative launched in early 2008, which sent out checks worth $131 billion.

Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers' hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.

As for the business tax package, a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don't sit on their money until after Congress passes the measure.

Another element would offer a one-year tax credit for companies that make new hires or forgo layoffs, which could be worth $40 billion to $50 billion. And the Obama plan also would allow small businesses to write off a broad range expenditures worth up to $250,000 in 2009 and 2010. Currently, the limit is $175,000.

William Gale, a tax-policy analyst at the Brookings Institution think tank in Washington, said the scale of the whole package is larger than expected. He called the business offerings a true surprise, since most attention has been focused on the spending side of the equation, especially the hundreds of billions of dollars being discussed for infrastructure and aid to state and local governments.

"On the other hand, it was hard to figure out how they were going to spend all that money in intelligent ways, so it makes sense to do more on the tax side," Mr. Gale said. His biggest question about the latest proposal concerns the credits for hiring new workers or refraining from layoffs. Much of that money would likely go to companies that would have hired more people anyway, he said, adding that it is impossible to know what firms would have done without such a credit.

Business lobbyists are pushing hard for Congress to allow companies that haven't paid corporate income taxes to get a break, too. Start-up companies, alternative-energy firms and large corporations that have been swallowing losses for years -- such as automotive and steel companies and some airlines -- have already begun lobbying for such "refundability."

They argue that a provision to claim losses on back taxes will have little effect on the economy if firms that need it most -- struggling companies that weren't obligated to pay any taxes -- can't benefit from a tax break.

Mr. Obama, however, doesn't back payments to companies that haven't paid taxes, aides said. Instead, businesses that haven't been paying taxes would be able to get payments from tax credits they would have taken in 2008 and 2009 for incentives offered by Congress, such as the production tax credit offered to renewable-energy firms. These amounts would likely be relatively small.

"We're working with Congress to develop a tax-cut package based on a simple principle: What will have the biggest and most immediate impact on creating private-sector jobs and strengthening the middle class?" said transition-team spokeswoman Stephanie Cutter. "We're guided by what works, not by any ideology or special interests."

As these details are being worked out, Mr. Obama and his family left Chicago during the weekend for Washington. He will be on Capitol Hill Monday, first to meet with House Speaker Nancy Pelosi (D., Calif.) and Senate Majority Leader Harry Reid (D., Nev.), then with the broader bipartisan leadership of Congress. The stimulus package will be front-and-center in those discussions.

Republicans are already criticizing parts of the stimulus package. Sen. McConnell, speaking Sunday on ABC's "This Week," questioned one of the biggest items, which would send as much as $200 billion to states largely to expand the federal share of Medicaid, the health program for the poor. He suggested structuring that aid as a loan, saying it would encourage states to "spend it more wisely."

An array of business tax cuts could help overcome such GOP opposition, enabling the Democrats to present their plan as a balanced mix of tax cuts and spending. It also would likely encourage business interests to lobby hard for its enactment.

Mr. Obama's team has spoken of wanting to attract significant Republican support, not simply picking up votes from a Republican moderate or two.

Obama aides have already enlisted business groups to rally behind spending for public-works projects. Norman R. Augustine, a former chairman and chief executive of Lockheed Martin Corp., will testify before the House Democrats' Steering and Policy Committee Wednesday in favor of an infusion of federal infrastructure spending. But the tax cuts may hold more sway with Republicans.

Warning signs that New Mexico Governor Bill Richardson would have trouble in his confirmation hearings to become Barack Obama's Commerce Secretary had been multiplying for weeks. It doesn't surprise seasoned New Mexico political observers that the two-term governor withdrew from his chance to join Mr. Obama's cabinet yesterday.

Mr. Richardson was caught up in what has become a major grand jury investigation into possible connections between the state's awarding of a lucrative contract and sizeable contributions a California company made to political action committees created by Governor Richardson. While the governor himself has not been publicly implicated so far, many of his political employees have given testimony to the grand jury.

Aides to President-elect Obama are already blaming Governor Richardson for the mess, saying that when his staff was asked for information on the grand jury probe "nothing" was forthcoming. But that's exactly the kind of answer a team of vetters for a future president isn't supposed to accept.

The problems with Mr. Richardson should have been evident to anyone with experience in machine-run Chicago. "Corruption is a way of life in New Mexico," says local blogger and novelist S.J. Reidhead, who maintains that the state's Democratic Party has been controlled by a corrupt machine for many decades. Perhaps it takes someone like Mr. Obama's Chicago pals to imagine Mr. Richardson's tainted backyard wasn't worthy of asking blunt questions about.

Another sign Mr. Richardson was in trouble came only a few days after he was appointed Commerce Secretary last month. On December 16, he abruptly ended a news conference by refusing to answer questions about the grand-jury probe of his office. Trip Jennings of the New Mexican Independent reported that Mr. Richardson's "abrupt departure was out of character for a governor who usually lingers at the end of news conferences to shake hands and mingle with individuals in the room. But on Tuesday he never made eye contact with the reporters."

Mr. Richardson's departure leaves Mr. Obama with a political dilemma, as Hispanic groups are already demanding that the Commerce Department vacancy be filled with another prominent Latino. Mr. Obama may feel he has checked off that diversity box with his appointment of California Rep. Hilda Solis as Labor Secretary. But he will face intense political pressure to make sure the Commerce Secretary post is held by an Hispanic too, especially since George W. Bush has had former Kellogg CEO Carlos Gutierrez in the job for the last four years.

-- John Fund

Richardson's Flameout and the Bush DOJ

The international etiquette expert he put on his staff; the large entourage he travels with in seeming practice for an international leadership post; the welcoming of North Korean emissaries to New Mexico's governor's mansion to solidify his diplomatic credentials; the careful cultivation of Barack Obama, for which he earned the rebuke of "Judas" from Clinton acolyte James Carville -- all these gestures and extravagances have been for naught, it seems. Bill Richardson will not be winging his way to Washington in style in anticipation of a cabinet post in the Obama administration.

Federal investigators are looking into why Beverly Hills-based CDR Financial Products won a contract to oversee a New Mexico bond offering shortly after the company donated $100,000 to a political campaign Mr. Richardson was running in 2004 to register Hispanic and American Indian voters. It is still too early to know if the investigation will find credible evidence against the governor himself, but one detail will likely escape intense media scrutiny: The investigation is a vindication for the Bush White House in its decision two years ago to fire David Iglesias, the U.S. Attorney for the district of New Mexico.

At the time, the firing of Mr. Iglesias and a handful of other U.S. attorneys became a hot button issue when Democrats and certain media outlets went wild with accusations that the White House was "playing politics" with law enforcement. Mr. Iglesias himself became a focal point in the controversy when it emerged that New Mexico Sen. Pete Domenici had pushed for his firing after finding the U.S. attorney slow in investigating political corruption in the state.

Amid the controversy, the White House never filled Mr. Iglesias's post, allowing Mr. Iglesias's deputy to hold the position on an interim basis. But about a year ago, a panel of federal judges acted on its own to appoint Greg Fouratt, a veteran federal prosecutor and former officer in the U.S. Air Force with New Mexico roots. Mr. Fouratt's office isn't commenting on the current investigation, but his willingness to press forward is a clear indication that New Mexico now has a robust anti-corruption unit in its U.S. attorney's office, something it didn't seem to have under Mr. Iglesias.

-- Brendan Miniter

Quote of the Day I

"[Fidel] Castro is as much a hero to the Left as [the late Chilean dictator Augusto] Pinochet was a bogeyman. At first blush, this is puzzling. Castro has executed 16,000 people and imprisoned more than 100,000 in labor camps. While liberals around the globe agonize over Guantanamo, they do not even know the names of the camps in Castro's gulag: Kilo 5.5, Pinar del Rio, Kilo 7, the Capitiolo, for children up to age 10 (political incorrectness can manifest itself at a very early age). Two million of Fidel's ungrateful subjects have fled his socialist paradise, more than 30,000 have died in the attempt. . . . Castro, who killed many times the number that Pinochet did -- and in cold blood -- remains a hero to the useful idiots of the western commentariat because murdering members of the bourgeoisie is just breaking eggs to make the Marxist omelet" -- Scottish columnist Gerald Warner, on the 50th anniversary of Fidel Castro's Cuban revolution.

Quote of the Day II

"Israel -- assuming it succeeds -- is doing the United States a favor by taking on Hamas now. . . . [A] defeat of Hamas in Gaza -- following on the heels of our success in Iraq -- would be a real setback for Iran. It would make it easier to assemble regional and international coalitions to pressure Iran. It might positively affect the Iranian elections in June. It might make the Iranian regime more amenable to dealing. With respect to Iran, Obama may well face -- as the Israeli government did with Hamas -- a moment when the use of force seems to be the only responsible option. But Israel's willingness to fight makes it more possible that the United States may not have to" -- New York Times columnist Bill Kristol.

How Burris and Franken Became a Matched Set

There was a reason that Senate Majority Leader Harry Reid told NBC News yesterday he is willing to "negotiate" a solution to the seating of Roland Burris, the Illinois Democrat appointed to take the vacant Senate seat held by Barack Obama until November.

One explanation for Mr. Reid's flexibility may be the political heat Senate Democrats would take for failing to seat an African-American in a body that currently has no blacks as members. But another is that Democrats might face charges of hypocrisy if on the same day they refuse to seat Mr. Burris, they move to seat Democrat Al Franken as the senator from Minnesota. A key argument Democrats are using to justify not seating Mr. Burris is that the Illinois Secretary of State is refusing to issue a certificate of appointment. But Mr. Franken, who currently leads Republican Norm Coleman by 225 votes, will lack a certificate of election from his state's Secretary of State when the Senate convenes tomorrow. While the state's canvassing board will likely declare Mr. Franken the winner today, Minnesota law holds that the Secretary of State can't certify Mr. Franken as the official winner until Mr. Coleman's expected legal challenge of the result is resolved.

But that hasn't stopped leading Democrats from moving to have Mr. Franken seated anyway. "With the Minnesota recount complete, it is now clear that Al Franken won the election. The Canvassing Board will meet tomorrow to wrap up its work and certify him the winner, and while there are still possible legal issues that will run their course, there is no longer any doubt who will be the next Senator from Minnesota," New York Senator Chuck Schumer said yesterday, echoing comments made last week by Minnesota's own Senator Amy Klobuchar.

If Democrats want to seat Mr. Franken despite the cloud hanging over the disputed recount that gave him a narrow lead only last week, they will have trouble explaining why they are denying Mr. Burris his seat, even though he had no role in Governor Blagojevich's alleged attempts to sell a Senate appointment. That's why Senator Reid now says the Senate could accept Mr. Burris if the appointment were made by a new Illinois governor or by Lt. Governor Pat Quinn, who is expected to become governor after Mr. Blagojevich is removed from office.

That says to me Mr. Quinn is being leaned on by Mr. Reid to signal that he would choose Mr. Burris if he becomes governor, thereby giving Democrats an out. But Mr. Quinn would simply be rubber-stamping the same choice that Senate Democrats thought unacceptable just last week. Senate Democrats should not be allowed to wiggle free of their previous position so easily, especially if they simultaneously try to seat Mr. Franken over the objections of Senate Republicans.

U.S. could be facing debt 'time bomb' this yearInvestors' thirst for American securities could finally be quenched

By Lori Montgomeryupdated 12:29 a.m. ET, Sat., Jan. 3, 2009

WASHINGTON - With President-elect Barack Obama and congressional Democrats considering a massive spending package aimed at pulling the nation out of recession, the national debt is projected to jump by as much as $2 trillion this year, an unprecedented increase that could test the world's appetite for financing U.S. government spending.

For now, investors are frantically stuffing money into the relative safety of the U.S. Treasury, which has come to serve as the world's mattress in troubled times. Interest rates on Treasury bills have plummeted to historic lows, with some short-term investors literally giving the government money for free.

But about 40 percent of the debt held by private investors will mature in a year or less, according to Treasury officials. When those loans come due, the Treasury will have to borrow more money to repay them, even as it launches perhaps the most aggressive expansion of U.S. debt in modern history.

With the government planning to roll over its short-term loans into more stable, long-term securities, experts say investors are likely to demand a greater return on their money, saddling taxpayers with huge new interest payments for years to come. Some analysts also worry that foreign investors, the largest U.S. creditors, may prove unable to absorb the skyrocketing debt, undermining confidence in the United States as the bedrock of the global financial system.

While the current market for Treasurys is booming, it's unclear whether demand for debt can be sustained, said Lou Crandall, chief economist at Wrightson ICAP, which analyzes Treasury financing trends.

"There's a time bomb in there somewhere," Crandall said, "but we don't know exactly where on the calendar it's planted."

The government's hunger for cash began growing exponentially as the nation slipped into recession in the wake of a housing foreclosure crisis a year ago. Washington has since approved $168 billion in spending to stimulate economic activity, $700 billion to prevent the collapse of the U.S. financial system, and multibillion-dollar bailouts for a variety of financial institutions, including insurance giant American International Group and mortgage financiers Fannie Mae and Freddie Mac.

Despite those actions, the economic outlook has continued to darken. Now, Obama and congressional Democrats are debating as much as $850 billion in new federal spending and tax cuts to create or preserve jobs and slow the grim, upward march of unemployment, which stood in November at 6.7 percent.

Congress is not planning to raise taxes or cut spending to cover the cost of those programs, because economists say doing so would further slow economic activity. That means the government has to borrow the money.

Some of the borrowing was done during the fiscal year that ended in September, when the Treasury added nearly $720 billion to the national debt. But the big borrowing binge will come during the current fiscal year, when the cost of the bailouts plus another stimulus package combined with slowing tax revenues will force the government to increase the debt by as much as $2 trillion to finance its obligations, according to a Treasury survey of bond dealers and other market analysts.

As of yesterday, the debt stood at nearly $10.7 trillion, of which about $4.3 trillion is owed to other government institutions, such as the Social Security trust fund. Debt held by private investors totals nearly $6.4 trillion, or a little over 40 percent of gross domestic product.

According to the most recent figures, foreign investors held about $3 trillion in U.S. debt at the end of October. China, which in October replaced Japan as the United States' largest creditor, has increased its holdings by 42 percent over the past year; Britain and the Caribbean banking countries more than doubled their holdings.

Economists from across the political spectrum have endorsed the idea of going deeper into debt to combat what many call the most dangerous economic conditions since the Great Depression. The United States is in relatively good financial shape compared with other industrial nations, such as Japan, where the public debt equaled 182 percent of GDP in 2007, or Germany, where the debt was 65 percent of GDP, according to a forthcoming report by Scott Lilly, a senior fellow at the Center for American Progress.

Even a $2 trillion increase would push the U.S. debt to about 53 percent of the overall economy, "only a few percentage points above where it was in the early 1990s," Lilly writes, noting that plummeting interest rates show that "much of the world seems not only willing but anxious to invest in U.S. Treasurys, which are seen as the safest security that an investor can own in a risky world economy."

Still, some analysts are concerned that the deepening global recession will force some of the largest U.S. creditors to divert cash to domestic needs, such as investing in their own banks and economies. Even if demand for U.S. debt keeps pace with supply, investors are likely to demand higher interest rates, these analysts said, driving up debt-service payments, which last year stood at $250 billion.

"When you accumulate this amount of debt that we're moving into, it's not a given that our foreign friends are going to continue on the path they've been on," said G. William Hoagland, a longtime Republican budget analyst who now serves as vice president for public policy at the health insurer Cigna. "There's going to come a time when we can't even pay the interest on the money we've borrowed. That's default."

Others say those fears are overblown. The market for U.S. Treasurys is by far the largest and most liquid bond market in the world, and big institutional investors have few other places to safely invest large sums of reserve cash.

Despite their growing domestic needs, "China and the oil countries are going to continue running large surpluses," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "They certainly will be using money elsewhere, but I don't think that means they won't give it to us."

As for the specter of default, Steven Hess, lead U.S. analyst for Moody's Investors Service, said even a $2 trillion increase in borrowing would not greatly diminish the U.S. financial condition. "It's not alarmingly high by our AAA standards," he said. "So we don't think there's pressure on the rating yet."

But that could change, Hess said. Nearly a year ago, Moody's raised an alarm about the skyrocketing costs of Social Security and Medicare as the baby-boom generation retires, saying the resulting budget deficits could endanger the U.S. bond rating. Even as the nation sinks deeper into debt to finance its own economic recovery, several analysts said it will be critical for Obama to begin to address the looming costs of the entitlement programs and signal that he has no intention of letting the debt spiral out of control.

Failure to do so, Bergsten said, would "create dangers . . . in market psychology and continued confidence in the dollar."

Turning off the entitlement-meltdown warning lightposted at 8:44 am on January 7, 2009 by Ed Morrissey

Democrats in Congress, led by Harry Reid and Nancy Pelosi, plan on a spending spree that will push budget deficits to a trillion dollars while an entitlement-system crash awaits us in the next two decades. Until now, a House rule has forced the lower chamber each year to acknowledge the disaster awaiting the largest entitlement program by debating Medicare’s funding and direction. Now, according to CQ Today (subscription required), Pelosi and the Democrats have a solution to Medicare’s collapse — change the rule to skip the debate:

House Democrats are planning to deal with one of their annual headaches early this year, using a rules package to turn off the Medicare “trigger” that each year forces an at least perfunctory debate on the entitlement program’s costs.

Buried in the package of operating rules that will govern the House in the 111th Congress is a provision saying the Medicare trigger “shall not apply.”

In a release accompanying the rules package, House Majority Leader Steny H. Hoyer, D-Md., called the Medicare trigger “an ideologically-driven target based on a misleading measure of Medicare’s financial health.”

The trigger is part of the 2003 Medicare overhaul law that also created the prescription drug benefit. According to the law, if for two years in a row, 45 percent or more of Medicare’s funding comes from general tax revenues, the president has to submit — and Congress debate — legislation to slow excess spending over a seven-year period and restore fiscal stability to the program.

The trigger went into effect for the first time last year. President Bush submitted a proposal to cut spending which House Democrats promptly dismissed. They then killed the requirement for debate in 2008 with a rule similar to the one they plan to adopt Tuesday.

In an interesting twist, the rule change will still require Barack Obama to submit proposals to fix Medicare, as required by the statute. The House will simply ignore them. This anomaly will exist because Democrats won’t propose this as an amendment to the 2003 law, but only as a simple rule change, which they can use to govern only their own behavior. They cannot use a rule change to let Obama off the hook.

Steny Hoyer says that ending the trigger “will allow Congress to consider all options for improving Medicare financing to provide a balanced and equitable solution.” That’s exactly what the trigger prompts Congress to do. Killing the Medicare trigger allows Congress to ignore Medicare and the looming financial crisis coming our way. Hoyer, Pelosi, and the rest of the Democrats in the House don’t want to be reminded that while they spend money like there’s no tomorrow in the 111th Session, tomorrow will eventually come — and their upcoming spending spree will have made the situation exponentially worse.

Basically, this is the same as fixing the ENGINE TROUBLE light on your car by covering it with electrical tape and then launching a 3,000 mile road trip. What could go wrong?

Last week the Treasury Department bought a $5 billion stake in GMAC as part of a plan to transform the lender, formerly the financial arm of General Motors, into a bank holding company. The New York Times reported that GMAC wanted to become a bank mainly so it could be considered a "financial institution" and thereby qualify for money from the $700 billion Troubled Asset Relief Program (TARP).

Yet the Treasury used TARP funds to invest in GMAC. In other words, if the Times has the story right, GMAC received TARP money so it could be eligible for TARP money.

This paradox highlights the lawlessness of the Bush administration, which has ignored statutory restrictions on TARP and treated it as a slush fund for politically favored supplicants. Although he has strongly criticized President Bush for flouting the law and exceeding his constitutional powers, President-elect Obama has applauded the latest manifestation of that tendency.

GMAC, which lends money to car dealers and buyers and also has dabbled disastrously in mortgages, has been bleeding billions for more than a year. In November, when it asked the Federal Reserve Board for permission to become a bank, the decision was based largely on the understanding that only financial institutions could receive help from TARP.

That was the Treasury's position, and it's not hard to understand why. The Emergency Economic Stabilization Act, which created TARP, authorized Treasury Secretary Henry Paulson "to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution," the aim being "to restore liquidity and stability to the financial system."

But by the time the Federal Reserve approved GMAC's application, Paulson had decided that G.M. and Chrysler, which make not loans but cars, nevertheless could receive $17.4 billion from TARP to tide them over until Congress approves more aid. His epiphany about the meaning of the TARP law came immediately after Congress declined to approve emergency short-term assistance for the carmakers.

"While the purpose of [TARP] and the enabling legislation is to stabilize our financial sector," Paulson said, "the authority allows us to take this action. Absent Congressional action, no other authorities existed to stave off a disorderly bankruptcy of one or more auto companies."

To Paulson's mind, a "disorderly bankruptcy" of G.M. or Chrysler was unthinkable. Since Congress had not authorized a bailout of the automakers, he decided to pretend it had.

Under Paulson's new interpretation of the law, a "financial institution" is whatever he says it is. Having decided that carmakers qualify, the Treasury last week declared that businesses tied to carmakers, such as parts suppliers, also can be covered by TARP.

In fact, the official rationale for the GMAC bailout, which included another $1 billion for G.M. to help it buy equity in the new bank holding company, was not GMAC's restructuring but its role in "a broader program to assist the domestic automotive industry in becoming financially viable." As far as Paulson is concerned, TARP aid to a money-losing lender is justified not by its relationship to restoring the financial system's liquidity and stability, the purpose for which Congress created TARP, but by its relationship to helping carmakers, a purpose not covered by the law that authorized the program.

You might think Obama—who proudly told The Boston Globe a year ago, "I reject the view...that the President may do whatever he deems necessary to protect national security"—would have something to say about the misuse of TARP. He does. He likes it.

Obama endorsed Paulson's illegal loans to G.M. and Chrysler, saying they were "a necessary step to help avoid a collapse in our auto industry that would have devastating consequences for our economy and our workers." Evidently Obama opposes only the unnecessary abuse of executive power. All the debate over what form the Obama-backed stimulus package should take may be pointless, since our next president seems to think he may do whatever he deems necessary to protect economic security, no matter what Congress says.

After I wrote a recent column on the fiscal mess in some states, I got an e-mail from a beleaguered New Jersey resident asking what I thought were the prospects for a tax revolt in the Garden State. It is an interesting and pertinent question because tax uprisings tend to occur during difficult and uncertain economic times, especially in places where the first impulse of state and local governments is to raise taxes to make up for shortfalls in revenues.

The two most notable tax revolts in recent memory, for instance, occurred in the mid-to-late 1970s and again in the early 1990s. Tax increases during those difficult years pushed the state and local government tax burden above 10 percent of income, on average, across the country and even higher in some places, like California, where it topped out at 11.7 percent in 1977. That helped spark perhaps the most notable of all state anti-tax campaigns, the Proposition 13 initiative of 1978, which capped property tax increases in the Golden State and inspired taxpayer uprisings elsewhere, leading to 13 similar tax caps, including Proposition 2½ in Massachusetts. Though expressed entirely in local initiatives, the anti-tax sentiment stirred up in those years was so powerful that it’s often credited with helping elect Ronald Reagan president in 1980.

Memories are short in government, however, and a decade later, when the American economy was again slowing, governors, mayors and legislatures began hiking taxes again, sparking the next tax revolt. One of the most visible victims of this uprising was New Jersey Gov. Jim Florio, who faced a $3 billion budget deficit in 1991 and promptly asked for $2.8 billion in new taxes--at the time the largest single-year tax increase ever imposed by a state. Although Jersey had been, as recently as the 1960s, one of the country’s most lightly taxed states, Florio’s tax increases, the culmination of a series of rises over the years, helped push the state and local tax burden in Jersey to 11.6 percent of total income — one of the highest in the nation. Since the Garden State didn’t have (and still doesn’t) California-style initiative and referendum, taxpayers displayed their ire by handing control of the state legislature to Republicans in mid-term elections and then dumping Florio two years later — the first sitting governor to be defeated in a reelection bid since Jersey had adopted its modern constitution in 1947.

In other states, meanwhile, the early 1990s tax revolt took the form of ballot initiatives to cap state spending levels, such as Amendment I in Colorado, which required that new tax increases be approved directly by voters.

Today, 44 states are facing budget woes that amount to a projected $90 billion in collective deficits in the coming fiscal year. Again, many governors and legislatures are pondering tax increases even as unemployment rises and people try to work themselves out of debt. New York tops the list with a whopping 88 new taxes and fees proposed by Gov. David Paterson, but he’s not alone. After raising taxes by about $1.1 billion in 2006, New Jersey Gov. Jon Corzine is hinting at new tax increases. California, Florida, Kentucky, Maryland, Nevada and Oregon are just some of the states that have either raised taxes or are considering such a move. The stage would seem to be set, in other words, for the next tax revolt in the states.

But the political climate has also changed dramatically since the early 1990s, and the next year or so may show whether state and local tax revolts are even possible anymore. Opponents of tax revolts—especially public sector unions, social service advocacy organizations that rely on government funds, and other groups that consume government resources—have grown much more powerful, and much savvier at fighting back efforts to trim the growth of government. After voters recalled California Gov. Gray Davis in 2003, startled public sector unions mobilized to derail a set of voter initiatives supported by his successor, Arnold Schwarzenegger, including one that would have limited the growth of the state’s budget. Public sector unions spent north of $50 million in the 2005 campaign against the initiatives, with the state’s teachers’ union alone kicking in $41.8 million.

In New Jersey that same year, public unions worked to derail a budding taxpayer revolt when they used their clout in the state legislature to water down a bill that would have created a constitutional convention to enact property tax reform. Under union pressure, legislators approved the convention but barred it from addressing government spending, which rendered a potential gathering useless.

In New York State, unions have been running ominous radio ads warning of sharp declines in services unless Albany raises taxes. Such ads can be devastatingly effective. A similar advertising campaign by health care interests in 1999, which warned of massive hospital closings unless the state increased aid to health care institutions, prompted worried New Yorkers to barrage hospitals with phone calls asking if they were about to shut their doors and provoked the head of one hospital association to accuse other health care groups in the state of employing scare tactics to further their goals.

Meanwhile, state politicians have quietly been working to make the initiative process tougher and thus limit the number of radical proposals like Proposition 13 that ever make it on the ballot. In 2007 alone, according to Governing Magazine, states enacted some 33 bills regulating the initiative process. In Florida, 60 percent of voters must now vote in favor of a ballot initiative in order for it to become law. In other states, those who gather signatures supporting ballot initiatives must now go through state-mandated training. Such rules will make in more difficult for ad hoc taxpayer groups that arise in response to political developments to be effective.

Still, one gets the feeling that most state politicians would not like to test the new, tougher systems that they’ve put in place. They’d rather have a President Obama come to their aid with direct federal funding for hard-pressed budgets, such as higher reimbursements for Medicaid, increases in federal dollars for local law enforcement, and more aid for K-through-12 education. Obama has, at one time or another in his run for the presidency, promised all of the above, although that was before the federal government committed $700 billion to bail out financial institutions. Recently Obama has offered states stimulus in the form of more infrastructure spending, which will do little to bolster budgets in the coming year.

So the stage may be set for a series of face-offs between beleaguered taxpayers and tax-eaters. If so, we’ll learn just how much the landscape has shifted since the last wave of tax revolts.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

Interesting article BBG. Where are those people now who pushed Prop 13 to the forefront? On my local front (Twin Cities, MN) in the past year we had 1) a tax increase handed to us by our county board to build a new MN Twins stadium. Strangely, it is a county tax for a state resource - actually a private business - and I live further from the stadium site than 100% of the residents of St. Paul where the tax does not apply. If you buy items outside the county and use them inside the county you are to file and send in the usage tax!!! We had 2) a gas tax hike from the state Dem. legislature, and worst of all 3) we had a statewide sales tax increase passed by the voters! If you opposed the tax increase then you are opposing clean water and wanting our lakes to become filth (even though we already pay a state agency to ensure water purity. Not exactly a tax revolt when a tax increase passes statewide by I think 8 points. My property taxes on my home in Minnesota are 20 times higher than on my home in Colorado.

(Meanwhile, 'Communist China' cut business tax rates in 2008 from less than ours to way less than ours...)

In the case of Obama, I know he said he would cut taxes on 95% of the people. I personally don't think his voters relied much on that as their reason for choosing him. I think he was pre-empting the promises that would come from his R. opponent. But in the case of tax increases on the rich he had to actually promise tax hikes to get elected and then back off from a governing perspective at least temporarily to keep from continuing to crash the economy. Unbelievable. My point is that I unfortunately don't see a tax revolt environment.

I frankly see more of a chance for revolt based on reckless use of public funds or play money from the Treasury - see SB Mig's post just preceding that characterizes Bush use of TARP funds as "lawlessness". Apart from the allegation of unlawfulness in process, what about the constitutionality (equal protection?) of government helping individual businesses, punishing others and the economic system ignorance of not letting failing enterprises fail. I think the revolt should be based this time on public spending and a turn back toward limits on government. Once we decide to contain spending - at ALL levels, we can look at funding.

Remember when Dick Cheney was pilloried for reportedly saying, earlier this decade, that "deficits don't matter"? We recall reading any number of press releases denouncing the Vice President for supporting tax cuts that contributed to short-term deficits but also helped the economy grow until the deficits shrank nearly away. Yet somehow none of those same voices are objecting now that the government is spending its way into deficits that are so large they dwarf any during peacetime in U.S. history.

The Congressional Budget Office released its latest budget forecast yesterday, and we now really do have red ink as far as the eye can see. Thanks to a 6.6% decline in revenues due to recession, a spending increase of some $500 billion or 19%, and assorted federal bailouts, the U.S. deficit for fiscal 2009 (ending September 30) will nearly triple to $1.19 trillion. That's 8.3% of GDP, which CBO says "will most likely shatter the previous post-World War II record high of 6.0 percent posted in 1983." It certainly blows away any deficit this decade, not to mention the Reagan years when smaller deficits were the media cause celebre.

But there's more. None of that includes the new fiscal "stimulus" that President-elect Obama has promised to introduce upon taking office in two weeks. The details aren't known, but Mr. Obama and Democrats have been talking about at least $800 billion, and probably $1 trillion, in new spending or various tax credits and reductions over two years. Toss that in and add more expected bailout cash, and if the economy stays slow the deficit could reach $1.8 trillion, or a gargantuan 12.5% of GDP. That 2006 Democratic vow to pass "pay as you go" budgets seems like a lifetime ago, which in political terms it was.

We've long argued that deficits per se are not worth losing sleep over, though we do recall when Robert Rubin and Larry Summers claimed that reducing them was itself an economic virtue because it reduced interest rates. With their acquiescence in the magnitude of these deficits, we trust they will now admit to burying Rubinomics as a serious economic philosophy. Democrats are once again all Keynesians now -- at least until they want to use the deficits as an argument to raise taxes in a year or two.

The Opinion Journal WidgetDownload Opinion Journal's widget and link to the most important editorials and op-eds of the day from your blog or Web page.As an economic matter, it does make sense to run deficits in a recession rather than to raise taxes in a way that would delay any recovery. Borrowing money to finance a war (Reagan's aircraft carriers in the 1980s) or to pay for tax cuts that promote growth (Reagan and Bush's tax cuts) is often money well spent. Had bipartisan Washington passed a big pro-growth tax cut a year ago, rather than settle in February for $165 billion in no-growth rebates and spending, the economy would be stronger and the deficit lower today.

The economically crucial issue for the long term is how much the government spends, because that is what becomes a claim on current or future taxpayers. This is where the CBO forecast gets scary. Including the Obama stimulus spending and assuming the full $700 billion of bailout money for the banks, insurance companies, auto firms and so forth gets fully spent, federal outlays could approach $4 trillion in 2009. That's double the $2 trillion Congress spent only seven years ago.

Federal expenditures are now rapidly outpacing the growth of the economy, which is expected to be negative this year. CBO estimates that even before the stimulus federal spending will climb to an all-time high 24.9% of GDP, up from the previous post-World War II high of 23.5% in 1985. Add the stimulus and bailout cash and we estimate the federal spending share of GDP will climb to 27.5%. All of this is fast pushing the U.S. to European spending levels, and that's before Mr. Obama's new health-care entitlements.

The problem with most of this spending is that it will be hard to stop once it becomes part of the annual CBO baseline. Congress never reduces spending year over year. While much of the $700 billion in Troubled Asset Relief Program money will probably be returned to the Treasury as banks redeem the government's preferred shares, Congress will want to turn around and spend that cash on other things unless the Obama Administration says no.

CBO also reports that some $240 billion of the new spending is for the bailout of Fannie Mae and Freddie Mac, which Congress will also want to keep in business as part of its nationalization of the mortgage market. So that $240 billion may never be repaid, though only last year our Solons and Treasury Secretary Hank Paulson were assuring us that Fan and Fred were no threat to taxpayers. Think of this as Congress having stolen from taxpayers as a result of its Fannie scam nearly five times what Bernard Madoff may have stolen from his clients.

Whether or not you think new spending will stimulate the economy, the one undeniable truth is that this money has to come from somewhere, which means that it is borrowed or taxed from the private economy. This spending blowout is all but guaranteeing huge future tax increases, and anyone who thinks only the rich will pay is living an illusion. Taxpayers need some new champions in Washington -- and fast.

Yes. I am still confused about this. This is just against all common sense.It reminds me of Gilder preaching that debt is good.I just don't get it. How can one argue we are not pushing our bills down the road onto future gnereations?

My understanding is that the true point is not deficit or not, but governmental burden on the economy. Taxes might be paying for all spending, but if the overall % of GDP is too high, that is the problem.

Crafty wrote: "Marginal tax rates IMHO are a matter of the deepest import."

- Absolutely true and people like Bush, McCain, even Palin forget or don't understand the other key words besides tax - 'marginal' and 'rate'. It isn't (just) taxes - the money - they take, it's the incentive to produce that gets badly eroded.

I wrote that the coming revolt should be based on limits on spending and limits on government based on my view of where the electorate might be. The bailouts and slush funds going into the trillions aren't wearing well on the people IMO. I still agree that marginal tax rates are extremely important. But marginal rates today are not where Reagan found them so the opportunity to cut further and the political opportunity to get a groundswell of support for that is smaller. OTOH, opposing increases in marginal tax rates is hugely important. I believe that just Obama's INTENT to raise investment taxes was one big factor in the asset selloff that collapsed values of everything from real estate to stocks, to bonds, to commodities, to money.

Cheney once said something like 'deficits don't matter'...

- I take that to be a partial sentence or partial thought, like getting Osama bin Laden is not important, meaning that it is not the only thing, the main thing or the first thing. It is still important!

Cheney was alleged to say in a policy argument that "Reagan proved that deficits don't matter". That was a quote comes from the writer who took it from an interview from the recollection of the person who was arguing tax cut proposals with Cheney, who also admitted they were interrupting each other, Paul O'Neill the former Treasury Secretary and a book about his service by Ron Suskind. The quote is also suspiciously provocative, as if to sell books, even if it might be exact or close to what was actually said. In fact, revenues again surged at double digit rates when the marginal tax rates were cut, surpassing CBO projections by hundreds of billions of dollars, and again th deficits were caused by excess spending. There is no indication that growth ended before the first phase-out of the 'temporary' cuts started Jan. 1 2008. Also growth did not end until investors and producers could see that the likelihood of tax cuts expiring was imminent and inevitable.

What Cheney should have said and I believe has said on explanation was that deficits in the 1980s did NOT have ANY of the effects on the economy that were predicted. In fact, interest rates and inflation both fell during that time. It did not crowd out private borrowing because we had a simultaneous explosion of growth. The cutting of marginal tax rates did NOT cause the deficits. Across the board tax cuts in the early 1980s resulted in revenues to the Treasury DOUBLING in the 1980s. The deficits were caused by excess spending in the form of a) compromises that Reagan had to make with a Democratic congress on domestic spending and caused by b) increased defense spending that was needed to bring down the Soviet empire, a worthwhile endeavor.

Deficits do matter. As CCP correctly points out they put a burden on the budget for interest costs and a burden on taxpayers of future years that carry the debt forward.

But deficits aren't the first thing in economic importance. As Crafty correctly points out, public spending takes resources away from the private sector and creates a burden whether you tax to pay for it or you borrow or you print the money. Bloated public sector spending is a burden holding back growth whether you tax, borrow or inflate. What people like Cheney or Gilder might point out is that a public sector taking half the resources of the economy using pay as you go and a zero deficit is a much larger burden on the economy than having the public sector take 20% of the resources but running a deficit at 1% of GDP. Gilder has made that point saying you could have a zero tax rate, but that IMO is for illustration and absurd in practice. I think all sides at least say we want to minimize borrowing and avoid runaway inflation.

'Debt is Good'. It means that you can do more and go further if you are not totally restrained by the timing of income and outflows of funds. That doesn't mean more debt is better or that what you invest in doesn't matter. Most families take on debt to live in a home while they pay for it. Alternatively, they could wait until accumulating 200k for a median home and then buy it. By then most families won't need the yard or the swingset because the kids will be turning 50. Same goes for a bridge over the Mississippi River and all the other public sector infrastructure projects that we need. We could tax now, put away the money and build the bridges later when we have all the money. Meanwhile, no one can reasonably commute across the river. Goods don't move and goods don't get sold across the river, etc. If we waited to pay for defense spending we might be speaking a Soviet language by now. Debt, properly used and structured, can be good.

I might add that the nature of the spending matters too. Maintaining and developing infrastructure (our electrical system is BADLY out of date for example, deep problems loom with water supplies as well) is very different than handing out money to people who pay no income taxes as President BO intends to do with his "tax cuts".

At first glance, Citigroup's endorsement last week of a Senate plan to allow bankruptcy judges to break mortgage contracts looks like a scene from "Goodfellas."

APSince October, the government has invested $52 billion in Citi, while agreeing to eat up to $249 billion in losses on the bank's toxic real estate portfolio. And so it's really hard to say no when those Washington "investors" call for a favor. In the 1990 Martin Scorsese movie, a restaurant owner realizes too late that a partner big enough to protect him is big enough to take everything he has. As Ray Liotta narrates, "Now he's got Paulie as a partner. Any problems, he goes to Paulie. Trouble with a bill, to Paulie . . . But now he has to pay Paulie."

The problem with Citi's capitulation is that it means that not just Citi will have to pay the Beltway outfit if the bill passes. Other banks, borrowers and taxpayers will also suffer. In fact, this deal is looking more and more like a case of Citi colluding with its new political owners in order to force competing banks to break contracts and take more losses. This kind of politicized banking is precisely why the Bank of the United States was shut down in the 19th century.

After years of resisting, Citi has suddenly signed off on Senator Dick Durbin's plan to allow judges to rewrite mortgage contracts for borrowers in Chapter 13 bankruptcy. Under the Illinois Democrat's plan, which is earmarked for inclusion in the pending stimulus bill, judges could reduce the amount of principal, lower the interest rate, and change the length of the mortgage term.

Until Washington embraced the politics of housing panic, even sensible Democrats recognized that allowing such mortgage "cramdowns" was a terrible idea, sure to punish future borrowers with higher rates as lenders calculate the increased risk. The Congressional Budget Office warned in January 2008 that such a change could result in higher interest rates for homeowners and bigger caseloads in bankruptcy courts. In 2007, 16 House Democrats signed a letter opposing similar legislation.

The Opinion Journal WidgetDownload Opinion Journal's widget and link to the most important editorials and op-eds of the day from your blog or Web page.They realized that the consequences would fall hardest on those hoping to buy a home, if markets logically respond by setting mortgage interest rates closer to those on, for example, auto loans or credit cards. A bankruptcy judge is now free to reduce amounts owed on many types of consumer debt. For mortgages, the iron-clad requirement to pay off the loan or lose the house is precisely to encourage lower rates on a less risky investment.

Supreme Court Justice John Paul Stevens described the importance of this principle in 1993 in Nobelman v. American Savings Bank: "At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual's interest in retaining possession of his or her home than of other assets. The anomaly is, however, explained by the legislative history indicating that favorable treatment of residential mortgages was intended to encourage the flow of capital into the home lending market."

Mr. Durbin argues that borrowers won't be able to enjoy the benefits of a cramdown until they first make an effort to negotiate new terms with their lenders before declaring bankruptcy. Also, to counter the perception that they are harming the mortgage market, Mr. Durbin and Senate colleagues Chris Dodd and Chuck Schumer are proposing that cramdowns only be available for mortgage contracts signed before their bill becomes law. But of course lenders will have every reason to assume that, whenever the going gets tough, Washington will let future borrowers break contracts too.

Mr. Durbin and his allies have tried and failed several times to break the cramdown opposition, and they believe Citi finally gives them the club to prevail. As Mr. Schumer noted in a press release, "Citigroup's support means that the dam has broken across the banking industry. We now have a real chance to pass this legislation quickly." Talking point number one for Democrats is that if giant Citigroup is for this plan, why would anyone oppose it?

In Today's Opinion Journal

REVIEW & OUTLOOK

Tehran's Strip Club

TODAY'S COLUMNISTS

The Americas: Dictatorship for Dummies – Mary Anastasia O'GradyInformation Age: How the Music Industry Can Get Digital Satisfaction – L. Gordon Crovitz

COMMENTARY

Charter Schools Can Close the Education Gap – Joel I. Klein and Al SharptonTake It From McCain's Advisers: The GOP Would Raise Taxes – Matt MillerWhy Russia Stokes Mideast Mayhem – Garry KasparovThe U.S. Votes 'Present' at the U.N. – John R. BoltonIn fact, Citigroup may support this plan precisely because it isn't a big player in the mortgage market. Sure, it has some dodgy mortgage-backed securities on its books, but they've been written down and the feds cover 90% of losses beyond $29 billion in any case. When it comes to making loans, however, Citi originates less than 10% of American mortgages.

Citi is falling further behind J.P. Morgan Chase, which acquired Washington Mutual; Wells Fargo, which acquired Wachovia; and Bank of America, which bought Countrywide. J.P. Morgan's mortgage business is now twice the size of Citi's, while Wells and BofA each originate almost three times as much dollar volume as Citi. So in agreeing to Mr. Durbin's offer, Citi is also volunteering its competitors to write down more mortgages, giving Citi a comparative advantage.

But the unintended consequences could make even Citi rue the day it got in bed with the goodfellas on Capitol Hill. If the possibility of this refinancing-via-bankruptcy encourages more people to declare bankruptcy, that would mean additional losses on Citi's credit cards and auto loans.

Having spent the past year committing taxpayer trillions to support American banks, Washington now seems not to mind at all if its latest bailout drives up bank losses on mortgages, credit cards and other loans. The Senate could soon make Paulie look like a reasonable business partner.

PETER WEHNER and PAUL RYANFor most of our nation's history, our approach to economics has favored enterprise, self-reliance and the free market. While the American economy has never been entirely laissez-faire, we have historically cared more about equality of opportunity than equality of results. And while Americans have embraced elements of the New Deal, the Great Society and progressive taxation, we have traditionally viewed welfare as a way to help those in dire need, not as a way of life for the middle class. We have grasped, perhaps more than any other nation, that there is a long-run cost to dependency on the state, including an aversion to risk that eventually enervates the entrepreneurial spirit necessary for innovation and prosperity.

Chad CroweThis outlook, once assumed, is now under attack due to a recent series of political and economic events.

The first is the unprecedented intervention by the federal government, in the form of a $700 billion relief package intended for our financial institutions after the credit crisis last September. This was followed by extending billions of dollars of federal assistance to America's auto makers in order to prevent their imminent bankruptcy -- the first emergency bailout that went to companies outside the financial sector. We understand why the federal government did this, and even supported legislation that, while hardly perfect, prevented an economic meltdown.

Nonetheless, the consequences of this undertaking are enormous. Not only has the size of the expenditures been staggering -- there is talk of another stimulus package worth an estimated $825 billion -- but we are witnessing a fundamental transformation of government's relationship with the polity and the economy.

The last several months are a foreshadowing of a new era of government activism, rather than an unfortunate but necessary (and anomalous) emergency action. We will soon shift from a market-based economy to a political one in which the government picks winners and losers and extends its reach and power in unprecedented ways.

The Opinion Journal WidgetDownload Opinion Journal's widget and link to the most important editorials and op-eds of the day from your blog or Web page.This shift is exemplified by the desire of President-elect Barack Obama and the Democratic Congress to push us toward government-run health care.

For all his talk of allowing consumers to select their own health-care coverage, Mr. Obama's proposal, as he laid it out in his campaign, will provide strong financial incentives for employers and individuals to sign up with a new, Medicare-style government plan for working-age people and their families. This plan will almost certainly use a price-control system similar to the one in place for Medicare, allowing it to charge artificially low premiums by paying fees well below private rates. These low premiums will serve as a magnet for enrollment and will devastate the private companies trying to compete in the health-insurance market. The result will be the nationalization of the health-care sector, which today accounts for 16% of U.S. gross domestic product.

Nationalizing health care will be profoundly detrimental to the quality of American medicine. In the name of cost control, the government would make private investment in medical innovation far riskier, and thus delay the development of potentially lifesaving treatments.

It will also put America on a glide path toward European-style socialism. We need only look to Great Britain and elsewhere to see the effects of socialized health care on the broader economy. Once a large number of citizens get their health care from the state, it dramatically alters their attachment to government. Every time a tax cut is proposed, the guardians of the new medical-welfare state will argue that tax cuts would come at the expense of health care -- an argument that would resonate with middle-class families entirely dependent on the government for access to doctors and hospitals.

Of course, this health-care plan is occurring against our particular fiscal backdrop: Without major reform, our federal entitlement programs will soon double the size of government. The result will be a crushing burden of debt and taxes.

In short, we may be approaching a tipping point for democratic capitalism.

While the scope of the challenge should not be underestimated, those of us worried about this fundamental reorientation of politics and economics have several things working in our favor. Among them is that a public accustomed to iTunes, Facebook, Google, eBay, Amazon and WebMD is not clamoring for centralized, bureaucratic government. The strong American instinct for individual initiative and entrepreneurship remains intact.

In addition, confidence in government -- from Congress to those responsible for oversight of the financial system -- is quite low.

Our sense is that at the moment, the public is not thinking in terms of "big government" or "small government." Instead, Americans want efficient government -- one that is modern, responsive and adaptive. People want government to act as a fair referee, providing guardrails that allow individuals to rise without intrusively dictating individual decisions.

If conservatives hope to win converts to our cause, we need to understand this new moment and put forward an agenda that reforms key institutions in a way that advances individual freedom, without creating an unacceptable level of insecurity.

This is no easy task, and it must begin with providing a compelling alternative to what contemporary liberalism and Mr. Obama are about to offer. This especially includes health care, where we must start by recalling that our current health-insurance system was designed to meet the needs of a 20th century economy and World War II-era employment laws. It is hopelessly outdated, yet the Obama plan would make the system even more sclerotic.

The core of our message needs to be a commitment to creating a health-care plan that meets the demands of the modern economy. We need to convince concerned citizens that we can help the uninsured find coverage in the private sector and use market incentives to contain costs. The result will be a system that makes it possible for everyone to afford health insurance, including those with pre-existing conditions.

Tax credits, high-risk pools, insurance choice and regulatory reform can form the basis of a transformation from today's enormously costly and inefficient third-party system into one driven by ownership, choice and competition. And at the nucleus of this redesigned system will be the patient-doctor relationship.

If we hope to succeed in making our case, it will require a concerted education campaign that relies on hard data and facts, rigorous and accessible public arguments, and persuasive public advocates.

This is quite a tall order. But if we do not succeed in resisting greater state involvement in the economy -- and health care is meant to be the beachhead of this effort -- we will move from a limited welfare state into a full-blown one. This will reshape, in deep and enduring ways, our nation's historic sensibilities. It will lead here, as it has elsewhere, to passivity and dependence on the state. Such habits, once acquired, are hard to shake.

Between now and the end of this decade may be one of those rare moments in which among other things will turn decisively one way or the other. The stakes could hardly be higher for our way of life.

Mr. Wehner, a former deputy assistant to President George W. Bush, is a senior fellow at the Ethics and Public Policy Center. Mr. Ryan, a Republican congressman from Wisconsin, is a member of the Budget Committee and the Ways and Means Committee.

Crafty, thanks for posting the piece by Wehner and Ryan. 'Paul Ryan, congressman from Wisconsin, member of the Budget Committee and the Ways and Means Committee' - is one of the potential up and coming voices IMO for electable conservatism - beyond Wisconsin. Also thanks for posting the Soviet plan from the current powers of the country. In my view, if we want growth, we just lean a little toward pro-growth policies, not rip up the best economic system in the history of the planet and replace it with what you aptly describe as a copy of the failed Soviet, centrally planned economy. As we contemplate further bailouts and phony 'stimuli', these contrasting views need to be studied side by side. I recommend re-reading the Wehner/Ryan piece point by point after the soviet plan and also I recommend the following piece of common sense from Victor Davis Hanson. He is not as pretty as the governor of our largest state but McCain would also have shocked the world by nominating VDH as running mate. The MSM would have imploded trying knock down his wisdom:

January 15, 2009Don't Waste a Crisis?By Victor Davis Hanson

Euphemism comes from the Greek word euphemia , which means "using the good word" -- usually in place of the accurate bad one. Recently we've become experts at it.

Printing trillions more dollars and growing government to cover new debts isn't so bad if we call it "stimulus." That is far smarter than saying something honest like, "I propose a new $1 trillion debt program."

The old-fashioned spendthrift policies we used to ridicule as congressional pork and "earmarks" are now justified under that ubiquitous nice word "stimulus." If funding another questionable museum in your district was once congressional pork barreling, it will now be a patriotic act to get the national economy moving again.

Yet much of what is driving this national hysteria in our reaction to the current economic downturn is psychological. After all, no plagues, wars or earthquakes have killed our workforce, destroyed our infrastructure or wiped out our computer banks.

Instead, for years now we have overspent and over-borrowed -- and must naturally pay up. And like any chastised debtor, panicked Americans logically have temporarily clammed up and are holding on to what money they have left.

In response, the government apparently doesn't only want to free up credit to get us back to our profligate habits of borrowing what we don't have so we can buy what we don't need. It also would like to create new programs to build infrastructure; guarantee new loans; and offer additional credits, bailouts and entitlements.

Or in the words of incoming White House Chief of Staff Rahm Emanuel, "You never want a serious crisis to go to waste."

Traditional conservative custodians of the budget can't say much. They are largely discredited on matters of finance. During the last eight years of Republican prominence in Congress and the White House, the government borrowed as never before.

Liberals in turn have suddenly rewritten their own economic history. They used to claim the great surge in government under President Franklin Delano Roosevelt got us out of the Great Depression with deficit spending and federal jobs programs.

But many historians have argued instead that unemployment and slow growth remained high throughout Roosevelt's first two terms -- until the Second World War scared us all into a fit of national mobilization that alone ended the ongoing 13-year depression between 1929 and 1941.

Now here's the irony: Liberals suddenly agree that only the Second World War stopped the Depression, after all! So they now argue that we need a new New Deal far greater than the old New Deal. In other words, they want to re-create the urgency of World War II to get government to grow and spend big-time.

Their argument is that if FDR failed to stop the Depression, it wasn't, as conservatives insist, because he turned to unworkable government solutions, but rather because he didn't try big enough ones.

The government-affiliated, under-regulated and corrupt Fannie Mae may have collapsed. And it may have helped to cause the sub-prime mortgage meltdown. No matter -- the proposed "don't waste a crisis" cure seems to use that model of government-guaranteed corporations to absorb as much of the economy as possible.

Still, no one knows whether the present borrowing and printing of money to give short-term credits, cash grants and jobs to Americans will get the economy moving again -- or simply reinforce the bad habits that got us here in the first place.

But consider a few facts: Even in the current mess, recent unemployment figures are around 7 percent -- not the 10 percent of the recession of the early 1980s, much less the 25 percent rate that peaked in the Great Depression.

Meanwhile, energy prices have plunged, saving consumers and the country hundreds of billions of dollars. The existing pre-stimulus annual budget was already set to run about a half-trillion-dollar deficit. The present government debt, much of it to Asia and Europe, was nearing $13 trillion even before the latest borrowing plans.

We are going to have to pay these debts back by cutting federal spending and entitlements or raising taxes -- or both. Or we can convince panicky debt holders abroad to loan us even more money for years at near-zero interest rates. Or we can try simply printing trillions of new dollars to inflate the economy while hoping that creditors don't mind being paid with funny money.

What got us in this debacle was the lack of self-control on the part of consumers who borrowed to spend more than they could pay back, rapid growth in government debt, and Wall Street speculators who wanted obscene returns they had not earned.

It would be a pity if the government now trumped these bad examples and turned some helpful federal loan guarantees of troubled banks into a permanent state-run economy with crushing debt for generations to come.

Victor Davis Hanson is a classicist and historian at the Hoover Institution, Stanford University, and author.

Mention of the ten year plan and vote counting shenanigans in the Minnesota senatorial election reminds me of a joke I haven't been able to tell for many years:

Did you hear about the burglary at the Kremlin? They stole the results for the next 3 elections.

The DC area is going absolutely batfeces over the impending coronation: They are closing all Virginia entry points into DC, all sorts of National Guardsmen called up, can't get to the mall with anything bigger than a fanny pack, hospitals are concerned about how their staff will get into the city, and so on. With the trillion dollar debt they are talking about racking up and the messianic intensity being pointed BHO's way, it sure is seeming like all the elements are in place for some incredible folly.

Besides last year's 'stimulus', we already had a $400 billion dollar stimulus from the reduction in energy costs. That boost could have occurred much sooner or we could have avoided the energy crunch altogether if government could have reduced its stranglehold on American energy production.

Everything today (Obama-Pelosi et al) is Keynesian. Pass a stimulus, the larger the better, what we spend it on isn't as important as how much... When you fund a government project for 12-18 months, what do you get at the end of the project? Let me guess, continued government funding or construction worker layoffs - AGAIN.

Wikipedia re. Keynes: "He advocated interventionist government policy, by which the government would use fiscal and monetary measures to mitigate the adverse effects of economic recessions, depressions and booms."

Keynesian interventions were applied to the so called 'Phillips curve' that stated basically that there is an inverse relationship between inflation and unemployment. Use inflationary policies for example to curb unemployment.

By the end of the 1970's, because of failed interventionist government policies, both inflation and unemployment were spiking, not offsetting each other. The activist government ran out of Keynesian interventionist tricks.

Then in the early 1980's both evils were contained with a non-Keynsian, two pronged approach, tight money to control inflation and lower marginal tax rates to restore the incentive to produce.

Now we head back to Keynes hayday, the prosperity of the 1930s.

In the late 70s or early 80s the WSJ published an editorial called "Keynes is Dead." I would like to find that and see if any of that wisdom might help our new leaders today.

From Bushanan post under the future (or lack thereof of the Republican party)I can't post a reply it keeps coming up "notify".So I'll post here:

***Philosophically, too, the country is turning away from the GOP creed of small government and low taxes. Why?

Nearly 90 percent of immigrants, legal and illegal, are Third World poor or working-class and believe in and rely on government for help with health and housing, education and welfare. Second, tax cuts have dropped nearly 40 percent of wage earners from the tax rolls.

If one pays no federal income tax but reaps a cornucopia of benefits, it makes no sense to vote for the party of less government.***

Yes, like I pointed out the immigrants of today are not the immigrants of our forefathers. Today they expect and we are stupid enough to give to them benefits or like they like to say, "entitlements".And as long as 40 % don't pay taxes the cans have that 40% who will never vote for them from day one.

W tried to pull some of these to the can party with the compassionate conservatism.

IT might have worked if not for Iraq, incredible Can spending from the houses, and the housing mess thanks to both parties.

This piece makes some interesting points. Comments?========================================As bank shares plunge to new lows around the world, it seems we have entered the next stage of the financial crisis -- most likely the last chapter in this horror story. The final word will probably be nationalization of the major financial institutions in the United States and the United Kingdom and in many other countries.

How has it come to this? The global credit crisis and the ensuing economic slump we are now entering have both ultimate and proximate causes. The ultimate cause was the ingrained social behavior of the U.S., the U.K. and many other economies over the past two decades that put instant gratification of consumption over the ability to pay for it. Thrift gave way to borrowing and excessive spending. That in turn led to huge global imbalances and distortions. The proximate cause of the crisis was how these excesses were financed through liquidity creation in innovative ways and in huge proportions.

Understanding these causes can explain why it has become so difficult to solve the crisis. Desperate to preserve the value of asset prices inflated by this huge liquidity bubble, policy makers have avoided the painful solution. The liquidity injections, the bailout programs, and the fiscal-stimulus packages try to sustain asset prices, when these prices need to fall to market levels so they can be cleared. The policy makers have just prolonged the crisis.

I am reminded of the clear conclusions of the World Bank's thorough analysis in a 2002 paper "Managing the Real and Fiscal Costs of Banking Crises," which examined banking crises over the past 50 years: "Accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalizations and debtor bailouts appear to increase significantly the costs of banking crises. Did these accommodating policies achieve faster economic recovery? We failed to uncover evidence that they did. Indeed, they seem to have prolonged crises because recovery took longer."

As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker.

There is nothing mysterious about the policy steps that need to be taken to get us out of this mess as quickly as possible. It is not rocket science. In fact, it was successfully carried out by the Scandinavian authorities back in 1991. The banks must be forced to disclose their "toxic" assets (the German banks have about 300 billion euros, the U.K. banks probably 200 billion pounds, and the U.S. banks maybe $800 billion). Then these must be written down to market prices with the hit being taken by shareholders and bondholders -- but not depositors. If that means most banks become insolvent, then so be it.

In effect, this function can be executed by the setting up of a "bad bank," as the Swedes did in the early 1990s. The bad bank clears the toxic assets off the books of banking systems by buying them at market prices and forcing write downs by the banks. A good bad bank forces banks to write down their bad assets and cleanse their balance sheets with those made insolvent being recapitalized, nationalized or liquidated by the state. But it is equally possible to use a bad bank to buy the banks' toxic waste at inflated prices so that the bank can start lending again. That's when it becomes a bad bad bank.

Unfortunately, so far, all the policy makers in the U.S., the U.K. and Europe have rejected the good bad-bank approach and we are now entering the third year of credit crunch with most banks already on their knees. Both the new U.S. administration and the current U.K. leadership are still in denial.

Last October, when the U.K. came up with a better blueprint for dealing with the credit crisis through recapitalization than the Bush administration's poorly conceived Troubled Asset Relief Program (TARP), I gave the Brown government credit for doing so, but faulted it for omitting the good bad-bank function. And now the latest U.K. bailout program, introduced because the October bailout is not working, has also eschewed the good bad-bank option and opted instead for an insurance guarantee scheme.

This new bailout package proposes to insure banks against losses on their remaining toxic assets. Banks will pay a 10% insurance fee, payable with either cash or equity. The taxpayers will take on the risk of losses on 90% of the toxic assets insured. The toxic assets remain on the banks' books, but the banks no longer have any risk in their exposure to them.

The government shied away from the good bad-bank solution because if toxic assets had been written down, most of the U.K. banking system would have been bust and forced into nationalization. In the U.S., the Obama administration is also apparently considering both the bad bank and the insurance solution. I fear they will opt for the latter.

It's natural for policy makers to say, "We know where the problem at the heart of the credit crisis is: it is a lack of lending and we must get credit flowing." If only it were that simple. What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the overleveraged. That cannot be achieved painlessly.

Indeed, household debt in the U.S. and much of Europe reached such extremes that today it is lack of demand -- rather than the impaired supply of credit -- that is driving the deleveraging process and deepening the economic recession. So it is unlikely that even politically decreed credit expansion would be effective in turning the economy around.

By not adopting the good bad-bank solution, the system remains as corrupted as before. The bad assets will continue to suck resources out of the economic system in the form of zombie borrowers, misallocation and mispricing of capital, public sector debt, and budget deficits. And as the reaction to the U.K. scheme is showing, avoiding the core problem fails to inspire confidence, so it is unlikely to result in any increase in aggregate credit or even forestall the inevitable nationalization of insolvent banks for long.

In today's money, the U.S. government alone has spent (counting fiscal spending, not Fed liquidity injections) a sufficient amount of money on the credit crisis to fund two Vietnam Wars. Around 90% of this spending has been to sustain lending and consumption, rather than to tackle the root causes of the credit crisis: overleveraged assets financed by excessive credit creation.

I suppose it is possible that the sheer weight of all this largesse will eventually overcome the structural failures of the financial system and produce economic recovery. (I doubt it, but I can't be sure because we've never been here before.) But if such profligate policies do produce economic recovery, they will do so by creating more bubbles, with the same ultimate consequences of collapse, though on an even grander scale.

Such a recovery would be welcomed by the markets and send traders back to the champagne bars of Wall Street and London. Eventually, however, the second crash would make today's look like kids' stuff.

Mr. Roche is president of Independent Strategy (www.instrategy.com), a London-based consultancy, and co-author of "New Monetarism" (Lulu Enterprises, 2007).

Timothy Geithner's tax oversights drew most of the media attention at his confirmation hearing, but the biggest news is the Treasury Secretary-designate's testimony Thursday that he'll ratchet up one of the Bush Administration's worst habits: China currency bashing.

APIn a written submission to the Senate Finance Committee, Mr. Geithner said the Obama Administration "believes that China is manipulating its currency." He says he wants Treasury to make "the fact-based case that market exchange rates are a central ingredient to healthy and sustained growth." The dollar promptly fell and gold jumped $40 on the news.

We're not sure what Mr. Geithner means by "market exchange rates," given that the supply of any modern currency is set by a monopoly known as the central bank. When Mr. Geithner says China is "manipulating" its currency, what investors around the world hear is that he really wants Beijing to restrain the number of yuan in circulation and increase its value vis-a-vis the dollar. That's a call for a dollar devaluation to help U.S. exporters.

This would seem to be an especially crazy time to undermine the dollar, given that the Treasury will have to issue some $2 trillion to $3 trillion in new dollar debt in the next couple of years. A stronger yuan would also contribute to Chinese deflation and slower growth, which would only mean a deeper world recession. Even the Bush Treasury never formally declared China to be a currency "manipulator" in its periodic reports to Congress. If the Obama Treasury is now going to take that step, hold on to those gold bars. We're in for an even scarier ride than the Fun Slide of the last few months.

January 25, 2009‘Soviet’ Britain swells amid the recessionAbul TaherPARTS of the United Kingdom have become so heavily dependent on government spending that the private sector is generating less than a third of the regional economy, a new analysis has found.

The study of “Soviet Britain” has found the government’s share of output and expenditure has now surged to more than 60% in some areas of England and over 70% elsewhere.

Experts believe the recession will tighten the state’s grip still further as benefit handouts soar and Labour directs public sector organisations to create jobs to soak up unemployment.

In the northeast of England the state is expected to be responsible for 66.4% of the economy this year, up from 58.7% when a similar study was carried out four years ago. When Labour came to power, the figure was 53.8%.

The northwest has seen a similarly relentless advance by the state, according to the research commissioned by The Sunday Times from the Centre for Economics and Business Research (CEBR).

“Labour has failed to encourage private sector investment across the country. Instead of supporting enterprise and small businesses, Gordon Brown has used the public sector to cover up his failures,” said Theresa May, the shadow work and pensions secretary.

The CEBR reached its estimates for 2008-9 by applying the 6.68% state spending increase announced in November’s prebudget report evenly across the country, although in practice some regions will receive more than others.

Across the whole of the UK, 49% of the economy will consist of state spending, while in Wales, the figure will be 71.6% – up from 59% in 2004-5. Nowhere in mainland Britain, however, comes close to Northern Ireland, where the state is responsible for 77.6% of spending, despite the supposed resurgence of the economy after the end of the Troubles.

Even in southern England, the government’s share of spending is growing relentlessly. In the southeast, it has gone up from 33% to 36% of the economy in four years.

The state now looms far larger in many parts of Britain than it did in former Soviet satellite states such as Hungary and Slovakia as they emerged from communism in the 1990s, when state spending accounted for about 60% of their economies.

Large-scale layoffs in the northeast will mean a rise in benefit payments. Newcastle-based Northern Rock was nationalised last year and has shed 1,500 jobs. Nissan announced three weeks ago that it was to cut its workforce in Sunderland by 1,200.

Many are finding new jobs in the public sector, according to One North East, the state development agency.

One of the biggest public sector employers in the northeast is the Department of Work and Pensions, which employs 13,400 there, hundreds of them in jobcentres.

“It’s not that the public sector in the northeast is too big, it is that the private sector is too small,” said Malcolm Page, deputy chief executive of One North East. “The decline of traditional industries in the past means we need to establish more big private-sector companies in the region.”

Latest figures from the Office for National Statistics show that since Labour came into power in 1997 jobs in the public sector have swelled by more than 500,000. In 1997, more than 5.1m people were employed in the public sector. The figure for 2008 is 5.7m.

However, Vince Cable, the Liberal Democrat Treasury spokesman, said that the state’s grip on the regions was likely to soften the impact of recession there.

“Newcastle and areas like that have a large public sector which will at least shield traditionally very depressed areas from the battering that southeast England is going to get.

“In the long term we need to do something about it. This does suggest the crowding-out phenomenon of the private sector and it also suggests there is a lack of entrepreneurial activity.”